SYNOPSIS: The Fed has realized how serious the liquidity trap really is.
Most of the headlines about the Fed's latest statement included the word "deflation." But that's not exactly what the Fed said. It warned of "an unwelcome substantial fall in inflation."
The point is that the Fed has its eye on the ball. It's not worried about deflation per se; it's worried about a liquidity trap, and about the possibility that the output gap can become self-reinforcing. In other words, it has a model something like the one I posted a few days ago. (Don't tell anyone, but Princeton - where the Fed's Ben Bernanke was department head until a few months ago - is the world center of the liquidity trap, inflation-targeting cabal: Bernanke, Lars Svensson, Mike Woodford, and yours truly.)
But can the Fed steer us away from the trap, without any significant help from fiscal policy? What if one more cut - which is about all that's left - doesn't do the trick? As this rather good piece in the Globe and Mail puts it, "Thatís when things start to get really interesting."
Originally published on the Official Paul Krugman Page, 5.7.03