Steve Williamson has a very good post on the Phillips curve and the Fisher effect. Because I have been encouraging macroeconomists to stop paying attention to inflation and start focusing on NGDP, I’m all for any and all attempts to mock inflation-oriented models like the Phillips curve.
Towards the end he suggests that if we want to avoid Japanese-style nominal stagnation we will have to raise interest rates. Yes, but how? The ECB tried that strategy in 2011 and the eurozone went right back into a double-dip recession. Then they had to cut rates to prevent the eurozone from collapsing. So I think we can all agree that the ECB’s way of getting to higher interest rates is far from optimal. And yet there is some truth to Williamson’s claim that a higher inflation equilibrium will involve higher steady-state interest rates than would a lower inflation equilibrium. But how do we get there?
The explanation is a bit complicated, so first I have to make sure that all readers accept the proposition that the reason we have 2% inflation in recent decades is not luck, and not fiscal policy, but rather monetary policy. Other long run inflation rates are feasible. We had zero inflation on average in the gold standard period. We had 8% inflation in the 1970s. In recent decades we have 2% trend inflation and not 0% or 6% or 16% because the central banks of the world decided 2% was the right number. God knows it wasn’t fiscal policy, Reagan greatly expanded the deficit in the early 1980s just as Volcker was bringing inflation down. Can you imagine Congress trying to target inflation at 2%? I believe the technical term is “ROFL.”
Why the emphasis on inflation? Because I’m going to talk from here on out like central banks control inflation, and by implication NGDP growth, at least in the long run when interest rates are positive. If that is true, then I define an easy money policy as a policy that will lead to higher expected price levels and NGDP ten years out, and a tight money policy as policies that will lead to lower expected price levels and NGDP ten years out, as compared to before the new policy is announced. And this brings us back to the ECB policy failure of 2011. The reason their policy failed is that they tried to raise interest rates with a tight money policy, whereas they should have tried to raise interest rates with an easy money policy. How do we know it was a tight money policy? Two reasons:
1. They said so.
2. They adjusted their policy instruments in a way that modern central bankers and asset markets recognize as having “contractionary intent.”
You might think “contractionary intent” sounds a bit metaphysical, but it is actually pretty important, as Michael Woodford showed that what really matters is not the current setting of the policy instrument, but rather changes in the expected future path of that instrument. Markets know that central banks determine the long run path of inflation or NGDP growth, and they care a lot about just where that path is set.
I still haven’t answered the question of how you raise rates the right way. Clearly it makes more sense to raise rates via the expected inflation and income effects (expansionary) as compared to the liquidity effect (contractionary.) Yes, but how do you do that, and how quickly can it be done?
Unfortunately the liquidity effect is quicker, indeed essentially instantaneous. The other effects take longer, at least at the short term end of the yield curve. I’ve often seen monetary shocks immediately affect long rates via the income and Fisher effects, but rarely short rates. The shortest term I ever recall being dominated by the Fisher and income effects was the 3 month T-bill yield, which fell on a tighter than expected monetary policy announcement in December 2007. But that was unusual.
As far as the how to raise interest rates question, that’s pretty easy. You simply target the price of NGDP futures along the desired growth path, and let markets determine the monetary base and interest rates. I believe interest rates would rise in a fairly short time with a 5% NGDP (level) target, perhaps a year or so. But it’s not really important how long it takes, because just as inflation doesn’t matter, nominal interest rates also don’t matter. Only NGDP growth matters.
PS. There is nothing unusual about the ECB’s failed attempt to raise rates in 2011. The exact same thing happened in Japan in 2000, and again in 2006. The same thing happened in the US in 1937. It’s what central bankers do; premature ejection from the zero rate bound. They are as anxious to tighten as a 16 year old boy. The markets need a lot of sweet talk first. Some forward guidance. Easing. You know what I mean.
PPS. Tyler Cowen recently made the following comment about money neutrality:
Milton Friedman, some time ago, wrote that money was for the most part neutral, and that the new money rapidly mixes in with the old. That made sense to me at the time, and it nudged me away from Austrian views, yet we have seen decidedly non-neutral effects from the various QEs and the periodic taper talk. -
This puzzles me. Friedman and Schwartz’s famous Monetary History was devoted to showing that monetary policy has non-neutral effects on output and asset prices. The Great Depression was one example they cited. Friedman favored QE in Japan precisely because he believed its effects would be non-neutral. So unless I have misunderstood Tyler, I think he misinterpreted Friedman. Perhaps he was thinking of long run neutrality, which I think almost everyone accepts.