Policy Puzzles

I can’t believe that! said Alice.
Can’t you? the queen said in a pitying tone. Try again, draw a long breath, and shut your eyes.
Alice laughed. There’s no use trying, she said. One can’t believe impossible things.
I dare say you haven’t had much practice, said the queen.
When I was your age, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.
Through the Looking Glass, Lewis Carroll (1871)

Here’s a possible final exam question…The Fed increases its nominal policy rate. Will inflation rise or fall?

So what’s your answer? Rise? Fall?

Hopefully, you know me better than to expect either answer is correct in all circumstances. Our world of intermediate macroeconomics is too complex, too nuanced for easy binary outcomes. The “right” answer, though you would need to explain it, is that “it all depends”.

A few years ago the blogosphere was replete with economists getting their heads in a spin over Neo-Fisherianism. It was all a bit silly, but – like any good puzzle – it did raise some interesting issues about causality, dynamics and stability; issues that good macroeconomists need to care about. If you want to dive deeper try this blog article from John Cochrane and these slides from James Bullard at the FRB St Louis.

Here’s the puzzle. Does higher inflation lead to a higher fed funds rate? Or does a higher fed funds rate lead to higher inflation? To put the question in a more contemporary context: did the Fed’s post-GFC hesitation in raising interest rates reduce or increase the risk of deflation?

The mainstream (liquidity) view is that higher interest rates, supported by temporarily lower monetary growth, would lead to lower inflation. Remember that the nominal interest rate is just the real interest rate plus expected inflation. If lower monetary growth is just temporary then there is no need for inflation expectations to change. This means that the higher nominal interest rate is reflected, one for one, in a higher real interest rate. That higher real rate temporarily dampens demand and thus actual inflation (relative to counterfactual trajectories).

But the Fisher (or neo-Fisherian) view says the opposite. Real interest rates are sticky since they are fundamentally driven by long-run forces of savings, productivity and global market conditions. Therefore, given that the nominal interest rate = “sticky” real rate + inflation expectations then higher nominal rates must largely be reflected in higher inflation expectations and thus higher actual inflation (with expectations of future monetary growth also increasing). If the Fisher view is right then, to avoid deflation, the Fed could have just raised interest rates without bothering with all that QE. Indeed, by not raising interest rates the central bank was actually undermining the impact of QE as a tool for lifting inflation expectations.

A little bit of thought suggests that the Fisher view puts too much reliance on long-run equilibria (expressed via identities) and pays insufficient attention to the dynamics of getting from A to B.

Comparing two different countries, both close to equilibrium, I would not be at all surprised if the country with higher inflation also had higher interest rates and vice versa.

However, if the country with high inflation decided it wanted permanently lower inflation then, as a practical matter, it seems very doubtful that cutting interest rates would do the trick. More likely, interest rates would need to rise a lot more first, reinforced by a recession to get the message embedded in expectations, before – ultimately – interest rates could fall to a lower level, commensurate with the desired lower inflation path. The Volcker disinflation of the 1980s provides a good example.

The debate is not new, as this 2001 piece from FRB Minneapolis illustrates. The key lessons to learn are that nothing can be taken for granted, that there is nothing new under the sun and that it’s good mental gymnastics to dream the impossible dream.

8 Apr 2021