Archive for the Category Inflation


Further thoughts on NeoFisherism

David Beckworth recently interviewed Stephen Williamson, who is an advocate of the NeoFisherian approach to thinking about monetary policy and interest rates.  Williamson argues that a policy of permanently reducing interest rates is disinflationary.  Others think this idea is crazy.  I’m not in either camp, and I keep looking for ways to explain why.  Here are some facts about monetary policy, which seem related to this issue:

1. In the short run, nominal interest rates can be reduced with a tight money policy.

2. In the short run, nominal interest rates are usually reduced with an easy money policy.

3. Because money is neutral in the long run, any monetary policy that permanently reduces nominal interest rates must be disinflationary.

4. A tight money policy reduces the natural rate of interest.

All of these claims are pretty easy to justify, and none seem particularly controversial.  But they raise an interesting puzzle.  Points #1, #3 and #4 all seem sort of NeoFisherian in spirit, consistent with the claims made by Stephen Williamson and John Cochrane.  So why are so many mainstream economists horrified by NeoFisherism?  I think the sticking point is #2.

The vast majority of the time, a reduction in interest rates on any given day represents an easier monetary policy than a counterfactual policy where the central bank doesn’t reduce interest rates.  Not always (in which case #1 and #3 would no longer be true), but the vast majority of the time.  But the NeoFisherian thought experiment requires that the lower rates be achieved via tighter monetary policy.

I think that people are confused about what NeoFisherians are talking about when they discuss policy option number three.  In the minds of most economists, switching to a permanently lower interest rate seems like an expansionary monetary policy, because on any given day cutting interest rates usually is an expansionary monetary policy.  Here’s why they are wrong:

1. If you don’t want the price level to blow up, then any permanent switch to a lower interest rate must be done with a tighter monetary policy.  If the central bank tried to do it with an easier money policy then they’d have to inject larger and larger amounts of liquidity, eventually causing hyperinflation and then complete collapse of the system.  So any sustainable policy of low interest rates must be contractionary.

2.  A contractionary monetary policy lowers the natural rate of interest.  I think many economists picture a world where the natural rate of interest is not affected by monetary policy.  In that world, lowering the policy rate makes policy more expansionary, because the stance of monetary policy is the gap between the policy rate and the natural rate (assumed to be stable).  In fact, any sustainable policy of low rates must be caused by tight money, and any tight money policy will reduce the natural rate of interest so much that monetary policy does not get easier, despite the lower fed funds target.  This is Japan since 1995.

So far I’ve presented a picture that is somewhat sympathetic to the NeoFisherians.  Let me conclude with a discussion of what I don’t like about the way NeoFisherians present their theory.

1.  The listener is led to believe that if you want lower inflation, you need to cut interest rates.  I’d say if you want lower inflation you need to cut interest rates via a tight money policy.  Any attempt to achieve lower inflation via a cut in interest rates achieved through an easier money policy will end in disaster.

2.  Because the vast majority of rate cuts represent easier money than the counterfactual of not cutting rates on that given day, it is not accurate to imply that the first step to lowering inflation is for the central bank to do the sort of rate cut that it often does do–i.e., liquidity injections.  Instead, the NeoFisherians should argue that the first step to lower inflation is for central banks to do the sort of rate cut that the Swiss National Bank did in January 2015, when they simultaneously appreciated their currency and created a credible policy of further currency appreciation going forward.  That credible promise led to lower nominal interest rates via the interest parity condition, and lower inflation expectations via the currency appreciation (combined with PPP.)

PS.  Has anyone commented on the similarity between the NeoFisherian puzzle identified in points #1 – #4 above, and the puzzle that led to the Dornbusch overshooting model?  The overshooting model was an attempt to resolved the following puzzle in a conventional Keynesian fashion:

Puzzle:  Easy money seems to lead to both actual currency depreciation and expected currency appreciation.

Rudi Dornbusch wanted to show how easier money could lead to expected currency appreciation (which is an implication of lower nominal interest rates combined with the interest parity condition.)  His solution was overshooting.

The NeoFisherian model assumes a permanent change in the interest rate, which rules out Dornbusch’s resolution to this puzzle. If you make the rate cut permanent than his solution no longer works; you take overshooting off the table.  In that case, the NeoFisherian result is the only explanation left standing.  Now it is a tighter money policy that reduces interest rates, and that tighter money also makes the currency become expected to appreciate forever, lowering inflation.

2.9%! (Good news for Yellen)

The recent wage report presents very good news for Janet Yellen:

It might have been slightly impacted by the hurricanes, but the loss of 100,000 low wage hospitality jobs in a 150,000,000 strong labor force isn’t very significant for aggregate hourly wages.  And that’s not just my view, the markets feel the same way:

Yellen is on a glide path to near perfection, as she will probably end her term achieving the Fed’s dual mandate better than any other chair in history.

So let’s replace her with someone lacking qualifications and a history of bad logic and bad judgement!

Was the zero bound holding back the Fed during 2009-15?

Most people thought the answers was yes.  I thought it was no.  Here’s a question for the zero bound worriers.  If the zero bound was holding back the Fed during 2009-15, then what’s been holding back the Fed over the past 20 months? Inflation is still below target.

Ignacio Morales set me an interesting graph from JP Morgan, which shows the correlation between global NGDP growth and growth in global profits:
Notice that the correlation seems particularly strong since 2009.

Ben Southwood sent me a ECB study by Luca Gambetti and Alberto Musso, which shows that the ECB’s asset purchase program worked via many different channels. Here’s the abstract:

This paper provides empirical evidence on the macroeconomic impact of the expanded asset purchase programme (APP) announced by the European Central Bank (ECB) in January 2015. The shock associated to the APP is identified with a combination of sign, timing and magnitude restrictions in the context of an estimated time-varying parameter VAR model with stochastic volatility. The evidence suggests that the APP had a significant upward effect on both real GDP and HICP inflation in the euro area during the first two years. The effect on real GDP appears to be stronger in the short term, while that on HICP inflation seems more marked in the medium term. Moreover, several channels of transmission appear to have been activated, including the portfolio rebalancing channel, the exchange rate channel, the inflation re-anchoring channel and the credit channel.

Ben Klutsey pointed me to a Larry Summers piece in the FT:

Historically, the Fed has responded to recession by cutting rates substantially, with the benchmark funds rate falling by 400 basis points or more in the context of downturns over the past two generations. However, it is very unlikely that there will be room for this kind of rate cutting when the next recession comes given market forecasts. So the central bank will have to improvise with a combination of rhetoric and direct market intervention to influence longer-term rates. That will be tricky given that 10-year Treasuries currently yield below 2.20 per cent and this would decline precipitously with a recession and any move to cut Fed funds.

As a result, the economy is probably quite brittle within the current inflation targeting framework. This is under-appreciated. Responsible new leadership at the Fed will have to give serious thought to shifting the monetary policy framework, perhaps by putting more emphasis on nominal gross domestic product growth, focusing on the price level rather than inflation (so periods of low inflation are followed by periods of high inflation) or raising the inflation target. None of these steps would be easy in current circumstances, but once recession has come effectiveness will diminish.


Nominal illusion

In order to better understand money illusion, it might help to consider some similar examples in other areas.  The Economist has an interesting story on the rare coin market:

The [rare coin] market’s wild-west days ended in 1986 when the first independent coin certifier, the Professional Coin Grading Service (PCGS), based in California, established itself as an authority on authenticity and quality. Grading each coin on a one to 70 scale, PCGS gave the market transparency, boosting investor confidence and sales volumes. Today, global sales of rare coins are estimated at $5bn-8bn a year, with 85% of the market in America. So important has third-party grading become that almost all rare coins sold at auction these days have been graded and sealed in stickered plastic by either PCGS or its main rival, Numismatic Guaranty Corporation (NGC), which is based in Florida.

Some blame the grading system itself for the eye-watering returns. Investors cling to the assigned grade: even a one-point boost can double or even triple a coin’s retail price. An 1884 silver dollar from the San Francisco mint, for instance, sells for $19,500 at the 62 grade but surges to $65,000 at 63.

The grading process is subjective: the evaluation criteria include “eye appeal”. Scott Travers, a coin dealer in New York, says investors sometimes resubmit the same coin ten or 20 times to the same company in hope of an upgrade. All this led to a steady “grade inflation”, that has been cheered along by investors. But in the long term, a sustained rise by simple fiat in the number of high-grade coins will surely depress prices. Already, a new type of “grader of graders” has emerged, hoping to instil some discipline by rating the consistency of the two primary graders. Next: graders of graders of graders?

This is, of course, another example of the sort of grade inflation that you see in American education.  What can we learn from this?

1. The incentive to inflate exists in both the private and public sectors.  I’ve heard that grade inflation is often worse in private schools, can anyone confirm?

2.  From a sociological perspective, the rare coin market is quite different from academia.  Whereas educators have a left wing bias, the rare coin world is more right wing.  So theories of academic grade inflation based on the left wing bias in education should be viewed with suspicion.

3.  In my view, monetary inflation, academic grade inflation, and rare coin grade inflation are partly motivated by what could be called “nominal illusion”, the tendency to see numbers as having the same meaning at two different points in time.  People wrongly assume that a dollar is a dollar, a 4.0 is a 4.0, and MS62 silver dollar is a MS62 silver dollar.

4.  In all three cases the illusion is only partial.  Workers feel better with a 10% raise during a period of 10% inflation, than a zero raise during zero inflation. That’s money illusion.  But they are not completely ignorant on this point.  They’d prefer an 8% raise with zero inflation to a 10% raise with 10% inflation.  Employers don’t know enough to completely look past the effects of grade inflation, which differ by college and by cohort, but they have some awareness that a 4.0 back a few decades is worth more than a 4.0 today.  And in the rare coin market, a coin that was graded MS62 a couple of decades ago has more value than one receiving that grade today.  If you look at rare coins on eBay, you’ll occasionally see references to the older form of packaging being used by the grading service, which makes the grade more desirable. It’s not just old coins that are more valuable; coins graded long ago are also more valuable.

5.  It’s possible that the incentive to inflate grades is greater than the incentive to inflate the money supply, because money is a government monopoly.  Think about the example of gasoline pricing in America.  Most consumers know that gas listed at 239.x a gallon is actually 239.9 a gallon, even though the 9 is so small that it’s hard to read.  Since almost all gas stations do this, any single station that did not would be at a competitive disadvantage.  My daughter told me that Berkeley does less grade inflation than other schools, perhaps because they are an elite government institution, with prices far below market.  They have a captive audience.  And government institutions have less entrepreneurial zeal. But I believe that most schools and most coin graders grade inflate because not doing so puts them at a competitive disadvantage.  I know that I inflated my grades over time because I wanted my student grades to be understood by employers, and I thought the best way of doing so was by grading under a similar set of criteria to other professors.  As they inflated, so did I.

6.  Contra Hayek, if we went to a system of competitive private monies, there is no reason to believe that issuers would keep the value of their currencies stable.

Is the Fed evil or misguided?

I say misguided, although many smart people think the Fed is intentionally undershooting its 2% inflation target, or treating it like a ceiling.  That would of course be evil, because it would mean the Fed is lying. Call me naive, but I still don’t quite accept that the Fed is a Trump-like institution. I believe they are misguided.

So what are the implications of my theory?  How can we test it?

If’ I’m right, then I believe that the Fed will eventually see that its reliance on the Phillips curve model has been a mistake. Low unemployment does not cause high inflation.  I expect this realization to occur at some point during 2018, at which time the Fed will switch to an easier money policy—to boost inflation.  I believe this because the market believes it, and (like Larry Summers) I’m a market monetarist.

This is one reason why I expect this expansion to be the longest in American history.  It won’t be the best (the 60s, the 80s, and the 90s were all better), but it will be the longest.  Switching to an easier money policy in the 9th year of an expansion is unusual.  It will prolong the expansion for at least a few more years.

I do not expect the Fed’s undershoot of inflation to cause a recession (although I wouldn’t entirely rule it out–it just seems unlikely.)  The economy has basically adjusted to 1.7% inflation.  The real problems with this are:

1.  A loss of Fed credibility, which will hurt them when the next crisis occurs.

2.  More zero bound episodes.

So the Fed needs to fix this problem.

BTW, there is nothing intrinsically wrong with 1.7% inflation during a period of low unemployment, if the Fed is a flexible inflation targeter.  Indeed in a sense that’s desirable.  But only if the Fed runs above 2% inflation during recessions.  And that’s why the Fed’s Phillips curve thinking is so pernicious.  The Fed fully expects inflation to fall during the next recession—the opposite of what they should be doing.  In that case the Fed needs to generate above 2% inflation during booms, in order to average 2% over the entire business cycle.  They are not doing so.

PS.  Stephen Kirchner directed me to an excellent Martin Sandbu column in the FT.  It does a great job analyzing the recent letter calling for a higher inflation target.  Indeed a far better job than I did in my recent analysis.  Here is the conclusion:

None of this means the target should not be reconsidered. But if there is going to be a change to what the Fed aims to achieve, one can do much better than a higher inflation rate target. One attractive possibility is to target a steadily growing price level rather than an inflation rate, which would require policymakers to pursue higher-than-target inflation for a while to make up for lower-than-target inflation in the past. Another is to consider targeting a path for the nominal size of the economy — nominal gross domestic product level targeting — which would allow for greater monetary stimulus when it is likely to do the most good.

PS.  The Larry Summers link above may be of interest to some people.