Thursday, March 30, 2017

Raise Rates to Raise Inflation

That's what Stephen Williamson is still arguing.

"recent data is consistent with the view that persistently low nominal interest rates do not increase inflation - this just makes inflation low. If a central bank is persistently undershooting its inflation target, the solution - the neo-Fisherian solution - is to raise the nominal interest rate target. Undergraduate IS/LM/Phillips curve analysis may tell you that central banks increase inflation by reducing the nominal interest rate target, but that's inconsistent with the implications of essentially all modern mainstream macroeconomic models, and with recent experience."

Wow. This is fantastic (fantastical?) stuff.

A couple questions for Neo-Fisherians. Both central banks and market participants believe that higher interest rates slow growth and inflation. If, in fact, higher interest rates raise growth and inflation, then, in a booming economy, why don't interest rate hikes and contractions in the money supply lead to hyperinflation? After all, central banks respond to high inflation by raising rates, which they believe will lead to lower inflation. If, instead, inflation goes higher, they will respond again with even tighter money.

Also, interest rate cuts are demonstrated to cause currencies to weaken. We know this, from, among other things, announcement effects using high-frequency identification. The evidence that real exchange rate movements impact the tradables sector is very strong, and merely relies on the theory that relative prices matter, the central teaching of economics. Then, is all of economics wrong, if prices don't matter?

We also know that market participants/the entire financial sector believes that low interest rates are good for the economy and profits and tight money is bad. We know this from market reactions to monetary policy. A series of interest rate hikes would raise borrowing costs considerably, cause the dollar to appreciate (which will affect inflation directly), cause the stock market to depreciate, and generally cause financial conditions to tighten. Thus, once again, to buy the Neo-Fisherian story, you have to believe that prices don't matter. In addition, you have to believe that markets aren't remotely efficient. Thus, you have to give up the central tenets of mainstream economics. Since "the market" believes monetary policy has the right sign, Stephen Williamson could make a lot of money by starting a hedge fund and betting on the "wrong" sign.

Hey, it's worth pointing out that people can disagree about monetary policy. Williamson (2012) says QE is hyperinflationary, while, on the other hand, Williamson (2013) says QE is deflationary. On the third hand, Williamson (2013; blog post) says money is just plain neutral. What's interesting here is that these are all the same Williamsons.

Thus it's worth peering into his intellectual journey.  First, after QE, despite high unemployment and a weak economy, he repeatedly predicted that inflation would rise. When it didn't happen, he changed his mind, which is what one should do. Only, he couldn't concede that standard Keynesian liquidity trap analysis was largely correct. That would be equivalent to surrendering his army to the evil of evils, Paul Krugman. Much easier to venture into the wilderness, and instead conclude, not that inflation wasn't rising despite low interest rates because the economy was still depressed, and banks were just sitting on newly printed cash, but rather that inflation was low because interest rates were low!

Fortunately, not all of Macro went in this direction, as Larry Christiano, a mainstream economist, discusses the Keynesian Revival due to the Great Recession.


  1. "Thus, you have to give up the central tenets of mainstream economics."

    No, that's the point. Neo-fisherite results are in fact mainstream. Essentially all mainstream macroeconomic models predict that higher nominal interest rates cause inflation to rise. But conventional views come from IS/LM/Phillips curve reasoning, with fixed expecations - I wouldn't hang my hat on that stuff.

    " If, in fact, higher interest rates raise growth and inflation..."

    No, I'm not saying that. Higher rates can indeed lower real economic activity in the short run.

  2. Thanks for posting Stephen. You're certainly a unique thinker, so I'm happy to have you posting here. Diversity of opinions is a great thing, and you certainly contribute to this in Macro.

    In any case, you wrote "Higher rates can indeed lower real economic activity in the short run." We are in agreement on the short-run impact. If so, then why would an already-depressed economy that is undershooting its inflation target (say, Europe/the US/Japan in 2012) want to lower real economic activity further?

    Second, that's a caricature of IS-LM. The framework is flexible enough to allow inflation expectations to shift.

    Third, what's the mechanism for the magic connector from the depressed economy in the short run from higher interest rates to the long-run growth? After all, in depressed economies, many firms go out of business, people drop out of the workforce, actual suicides happen, birth rates decline, people leave for greener pastures. Not all of this can be undone.

  3. I've often wondered if raising interest rates would bolster the economy. I know a lot of retirees who have cut back their spending because of low interest rates. Most of them have other investments, but they are higher risk and longer term. When you hit your 60s or 70s, you have to rethink your financial horizon. Most borrowed money these days goes towards financial engineering and consolidating trusts that reduce competition. These actually fight innovation and raising productivity.

    Too many economists don't understand the economy at an accounting level, so they draw broad brush rules that describe emergent behavior. Physicists, chemists and biologists are used to finding apparently contradictory behavior, since they recognize that they are dealing with complex systems built from smaller components. Economists seem to be stuck in the 18th century and are philosophically vitalists.

    1. "I've often wondered if raising interest rates would bolster the economy."

      Really, the answer is no.

      "I know a lot of retirees who have cut back their spending because of low interest rates."

      I'm skeptical that retirees' spending is relatively more elastic with respect to the state of the economy than other groups. I suspect that 40 year olds looking to buy/build houses have relatively more depressed spending. It's been known for a long time that central bank policy largely in large part through the housing market.

      However, there are three other reasons to think this is wrong. Bond prices and interest rates are inversely correlated. Imagine the poor grandmother, too conservative to invest in stocks, which are at an all-time high, living off interest payments from her bond fund (and Social Security). Well, any bond she bought before 2008 has appreciated in value thanks to low rates (price and interest rate are inversely correlated). Second, to the extent she held it to maturity, she locked in the earlier higher rate. What's more, if you raise rates now, the price of that 30 year bond this poor grandma owns is going to go in the toilet. Pretty soon, Grandma is going to have to skip bingo night.

      Third, typically, people switch about 8% of their portfolio out of stocks after retirement. Thus, retirees also invest in stocks and real estate. Loose money is good for these other asset groups as well. Low interest rates on risk-free government assets do encourage people to make real investments.

  4. Doug,

    I think you may be underestimating the neo-Fisherian proposition a little. According to Cochrane, Woodford himself acknowledged that a basic NK-model has neo-Fisherian implications:

    Also Gabaix seriously considered it in a recent paper:

    " a permanent rise in the interest rate decreases inflation in the short run but increases it in the long run."