When it comes to monetary policy, Franklin Roosevelt probably had it right: All we really have to fear is fear itself.

For several years, economists have struggled to explain why a monetary policy of low interest rates has not returned the economy to full prosperity.

After all, low rates worked in the past by generating business activity, which rights the economy. Or at least that’s the way it seemed, and that’s what a lot of economists, including the last two chairmen of the Federal Reserve, believed.

But now, five years after the collapse of 2008, a lot of people, including economists, are wondering why things have not returned to pre-recession levels.  

You can’t pick up a newspaper or magazine that does not bemoan all the people left behind by the current recovery.

So, what is the problem?

It comes down to “a couple conundrums,” economist Jim Paulsen explained last month in his newsletter to customers of Minneapolis-based Wells Capital Management. Paulsen, who tracks huge volumes of economic data, identified the conundrums as:

1. A decline in monetary velocity, which is a measure of how quickly the Federal Reserve’s changes in interest rates move through
the economy.

2. An atypical correlation between stock and bond returns, which is investor-speak for the fact that both stock prices and interest rates are unusually low today. Typically, when one is down the other is up, and vice versa.

Paulsen’s review of historical data shows that the current double conundrum has only happened twice before: during the Great Depression and the World War II era.

It’s something of a chicken-and-egg scenario, because we don’t know which causes which. That doesn’t really matter, he said, because as long as both are ongoing, the economy will remain stuck.

The one thing that is clear is both “seem to be driven more by confidence and fears than by fundamental economic issues.” But once fear sets in, it’s hard to stop.

Paulsen’s newsletter goes through four different scenarios: what happens when inflation is above 5 percent, when it is in the 2-5 percent range, when it is between zero and 2 percent, and when the economy is in deflation. In each case, he explains typical investor mindsets and lays out what the challenge in each situation is for the Federal Reserve.

During periods of zero to 2 percent inflation, which is what we’ve had for some time, “the investment community oscillates between a return to ‘normal’ or the ‘end of the world,’” Paulsen said.

I’d say that’s a pretty good description for what I hear these days from my investor friends.

For every bull, there’s a bear, and neither has a lot of confidence about anything.

The question then becomes: How do we get out of this?

The answer is easier to say than do: Get rid of fear.

The way to do that is to re-inflate the economy back to the 2 percent to 5 percent range. When inflation is in that range, Paulsen said, Fed changes in the interest rate actually do have an effect on the larger economy, and the correlation between stock and bond returns goes back to normal.

The Fed’s policy of trying to keep interest rates too low for too long hurts the economy because it scares people. It is “a message to investors … that the Fed believes the economy remains weak, broken and vulnerable,” Paulsen said.

It is better to let rates rise, which appears to be what the Fed has started doing.

The goal going forward should not be an interest rate target, but to keep inflation in the 2-5 percent range, which is where the economy seems to function best.