Does that question seem incomplete? Then try this one (from a commenter):
If the Fed raised interest rates how would that affect inflation?
Still maddeningly incomplete? Then how about this one:
If the Fed adopted a more expansionary monetary policy, how would that affect inflation?
Finally we have a real question! People often seem to forget that changes in interest rates are an effect of “the thing the Fed does” whereas monetary policy is “the thing itself.”
The first question should have been:
If the Fed adopts an expansionary monetary policy how will that affect interest rates?
Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation. But there is an unambiguous relationship between monetary policy and inflation. Easy money leads to higher inflation (ceteris paribus) and vice versa. But exactly what is easy money? And why can’t we talk about changes in the fed funds rate as being “the thing itself?”
First of all, the fed funds rate is not always equal to the fed funds rate target, so obviously there are forces beyond Fed policy that influence that rate. It is affected by Fed policy, but it isn’t the thing itself. Here’s what I mean by easier money:
A policy that increases the supply of base money or reduces the demand for base money is expansionary. Here are ways to increase the supply of base money:
1. Open market purchases
2. Discount rate cuts
Here are ways to reduce the demand for base money:
1. Lower reserve requirements.
2. Lower interest on reserves.
None of these policy changes will have much effect if temporary.
And here is a very reliable way to signal an intention to adopt an easier monetary policy (usually an intention to boost the base through open market purchases):
1. Lower the fed funds target, relative to expectations.
That signaling device has been so reliable over the years that central banks have been able to see a clear connection between their policy signaling and asset prices linked to inflation expectations (such as stock and commodity prices, or TIPS spreads.)
It is that reliable response of asset prices to unexpected fed funds changes, i.e. unexpected changes in the expected future path of the base, that causes central banks to be absolutely confident the neo-Fisherites are wrong. They see evidence of their policies “working.” But here are two facts that lead to confusion:
1. The vast majority of the time interest rates and inflation are positively correlated—the Fisher effect dominates the liquidity effect.
2. Central banks and their supporters in the academic community often talk as if interest rates are “the thing itself.” That’s incorrect, and it leads them to often confuse easy and tight money, because of point 1.
Combine those two facts, and it’s easy to understand how intelligent, freethinking economists might reject the conventional wisdom, and end up as neo-Fisherites.
The solution is not to throw out mainstream Keynesian monetary theory and embrace neo-Fisherism, the solution is to throw out mainstream Keynesian monetary theory and embrace market monetarism.
Like Coke, it’s
the real thing the thing itself.
PS. Off topic, but I only hate Noah on days where he insults me or my friends on Twitter, otherwise I like his blog a lot. Love the sinner, hate the sin.
And a person Miles and Izabella like can’t be all bad. :)