The Cure for Neo-Fisherism: History

Noah Smith reports there is a "rebellion" brewing in macroeconomics. Some economists, including Stephen Williamson, John Cochrane, and Stephanie Schmitt-Grohe and Martin, are promoting a very provocative idea that challenges standard monetary economics. They argue that a central bank holding interest rates low for a long period will cause inflation to fall. The conventional view is that such actions should cause inflation to rise. This unorthodox view was first popularized in a 2010 speech by Minneapolis Fed President Narayana Kocherlakota who invoked the famous Fisher relationship to make his case:

The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

Kockerlakota has quit making this argument, but others who continue to do so often invoke the Fisher relation too. Here, for example, is Stephen Williamson:

 In the long run, standard asset pricing gives us the Fisher relation, which is 

R = r + i, 

where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate...Therefore, in the long run, if R is targeted at its lower bound by the central bank, 

i = - r - t 

So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.

The policy implication for today is that the Fed should consider raising its target interest rate soon or face the prospects of lower inflation. Given this view's reliance on the Fisher relation, Noah Smith has called this group the Neo-Fisherites. Smith, himself, acknowledges being lured by the siren calls of Neo-Fisherism. It is all so elegant and straightforward, so why not?

There are two reasons to be leery of Neo-Fisherism. First, it ignores Wicksell's cumulative process. This idea says that if the central bank pegs the short-term nominal interest rate below the natural interest rate the price level will eventually explode and vice versa. The Fisher relation is an equilibrium condition and says nothing about this disequilibrium dynamic. Rajiv Sethi and Nick Rowe note that once one acknowledges the potential for the Wicksellian cumulative process, it becomes apparent that the Fisher relation itself is not necessarily a stable equilibrium. These concerns are why the Taylor Principle is such a big deal in macroeconomics.

Second, Neo-Fisherism has been tested in the real world and failed. There are several historical experiences where monetary authorities pegged short-term interest rates for an extended period and they did not end in deflation. Also, there are other more recent experiences that raise doubts about Neo-Fisherism. Let's take a look at them.

Germany During and After World War I

Robert Waldman reminded us of this natural experiment back when Kockerlakota made his 2010 speech. Here is Waldman:

I think that it is important that in monetary models there are typically two equilibria -- a monetary equilibrium and a non-monetary equilibrium.

The assumption that the economy will end up in a rational expecations equilibrium does not imply that a low nominal interest rate leads to an equilibrium with deflation. It might lead to an equilibrium in which dollars are worthless.

I'd say the experiment has been performed. From 1918 through (most of) 1923 the Reichsbank kept the discount rate low... and met demand for money at that rate.

The result was not deflation. By October 1923 the Reichsmark was no longer used as a medium of exchange.

The Reichsbank pegged its official bank discount rate at 5% from 1915 through 1922. That is long enough to test the Neo-Fisherite view. The Figure below shows what happened: an explosion of the price level.

The next figure goes through 1923 where the price level really takes off. Here I put the price level in natural log to make the graph readable. Note that eventually the explosive inflation is followed by a rise in the nominal interest rate. So this experiment shows (1) a central bank pegs an interest rate too low for an extended period, (2) inflation begins to surge, and (3) the pegged interest rate is eventually forced up. This is the causality laid out in Wicksell's cumulative process. Strike one for Neo-Fisherism.

The United States and the Accord of 1951

From April, 1942 to March, 1951 the Fed pegged interest rates to help the government's financing of World War II.  Treasury bills were pegged at 0.375% while long-term bonds were set at 2.5%. During the war this arrangement was tolerated (and aided by price controls), but with the end of the war the Fed was eager to get out of this "straightjacket" as inflationary pressures built because of the Wicksellian cumulative process. This can be seen in the figure below which goes through 1948.

By February, 1951 CPI growth at annualized rate reached about 20%. A few months later the famous Treasury-Fed Accord was signed that gave the Fed independence. The figure below shows the struggle the Fed was facing between the end of World War II and the Accord. The Wicksellian process was unfolding and the Fed sorely wanted to raise interest rates enough to stem it. Here too we see (1) a central bank pegs an interest rate too low for an extended period, (2) inflation begins to surge, and (3) the pegged interest rate is eventually forced up. Strike two for Neo-Fisherism.

Canada Over the Past Twenty Years.

Nick Rowe provides us a different type of real-world example that challenges the Neo-Fisherite veiw:

For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%.

The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate.

If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

Strike Three for Neo-Fisherism. If they had not already struck out, I would also pitch Abenomics at the Neo-Fisherites. It is still a work in progress, but the evidence so far should give Neo-Fisherites pause.

The point of these examples is that history is filled with many examples of monetary policy regimes that violate Neo-Fisherism. In fact, it is hard to come up with examples that unambiguously fit the Neo-Fisherite view. For example, some proponents point to Fed policies and the low inflation rate over the past few years as evidence for Neo-Fisherism. However, there are empirical studies that show QE has actually raised inflation in the United States. And arguably, the reason the Fed's programs have not packed more of a punch is their temporary nature. In short, there is little solid evidence for Neo-Fisherism while there is much for the conventional view. So be very leery of Neo-Fisherism.

Update: Josh Hendrickson speaks to Stephen Williamson and learns that Williamson, Narayana Kocherlakota, and Milton Friedman actually are saying the same thing. Here is Josh:

The argument he was making was essentially that if the Federal Reserve chose to leave the interest rate at zero for an extended period of time, this would imply that eventually they would have to pursue a policy that was deflationary. If they didn’t pursue that type of policy, they couldn’t maintain their peg of the nominal interest rate. In addition, since we don’t expect the Federal Reserve to pursue a policy consistent with negative rates of money growth, the statement should be seen as a criticism of the Federal Reserve’s original attempt at forward guidance which suggested that the FOMC would keep the interest rate at zero for an extended period of time.

If only that had been made clear sooner!