Zero Bound and the Fed's Dire Straits

Paul Krugman has this amazing graph that I will reproduce it here:



Some context for all you non-econ-geeks. The Tayor rule is the standard econometric equation predicting what the Fed Fund rate would be. It basically says the the projected Fund rate is determined by deviation from equilibrium inflation rate and output.

We, of course, are presently way off the equilibrium.

The intuition is this: the Fed uses fund rate so as to manage optimality in the overall economy. Inflation too high? Raise the fund rate. in a recession? lower the fund rate.

Here is the problem: based on how far we are off the equilibrium, the Fed would have to lower the fund rate to -6% (negative!) to fully manage the economy, using the Taylor rule. This is what they mean when they say the Fed is out of bullets. You can't charge negative interest rate. and having run out of room, the Fed now cannot manage the economy.

This is why a $800 billion fiscal stimulus is on the table, so as to prevent the economy from circling down the drain. This gives you a sense just how dire we think this current economic downturn might be....