Was NeoFisherism vindicated?
Rajat directed me to a new post by Stephen Williamson, which suggests that recent events provide support for the NeoFisherian view. The Fed has been gradually raising their interest rate target since late 2015, and inflation has gradually risen from near zero up to roughly 2%. In addition, nominal interest rates are positively correlated with inflation rates at the international level.
Here are three ways of interpreting that evidence:
1. Higher interest rates cause higher inflation. (NeoFisherism)
2. Low unemployment led the Fed to fear inflation (Phillips Curve), and they tightened monetary policy to prevent inflation from overshooting. (Keynesian)
3. The Fed did not tighten at all. Contra NeoFisherism, raising the interest rate target is usually contractionary, ceteris paribus. But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising. This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy. I would argue that 2017 was no different. So I also reject the Keynesian view.
I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target. And I prefer the third explanation to the second because the Phillips Curve is not a reliable way of forecasting inflation, and changes in the nominal interest rate are not a reliable indicator of changes in the stance of monetary policy.
Off topic, I just returned from a monetary conference at the Hoover Institution, which was attended by no fewer than 4 Fed presidents. I was delighted to see both John Williams (who was recently appointed to the New York Fed), and Robert Kaplan (Dallas Fed) mention both price level and NGDP level targeting as promising options to think about. While neither endorsed these policy options, I had the impression that if the Fed were not already committed to inflation targeting, these two Fed presidents would probably be favorably inclined to one of these two approaches. Kaplan seemed especially interested in NGDP targeting. However, I don’t expect the Fed to change its policy target as long as things are going well. Instead, I’d expect some consideration of level targeting the next time we go into a recession, and hit the zero bound.
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7. May 2018 at 04:35
Thanks for the post. I don’t have the expertise or interest to understand their formal models, but I would love to know how NeoFisherians like Williamson see the transmission mechanism from higher nominal interest rates to higher inflation.
Maybe I’m misunderstanding, but you say, “I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target.” But Williamson’s post ends with, “And tightening means a negative effect on real economic activity and a positive effect on inflation.” That suggests he believes that higher interest rates would not be inconsistent with lower asset prices.
7. May 2018 at 05:08
Good post.
While I do believe that there is some relationship between labor market slack and wage/price setting behavior, I do not think the relationship is that strong or even useful for monetary policy making.
While Neo-keynesians have incorporated the Wicksellian interest rate in their models, most of them would rather agree with 2, I guess.
Knut Wicksell, on the other hand, agreed with you that rising prices (inflation) are usually associated with higher interest rates and lower prices are associated with low interest rates. That is because the profit rate (or return to capital) is high in booms and low in busts. The money rate set by the Central Bank tends to follow the natural rate with a lag.
See his essay: Second part of paragraph 15
http://www.econlib.org/library/Essays/wcksInt1.html
7. May 2018 at 07:21
“[R]aising the interest rate target is usually contractionary, ceteris paribus. But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising. This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy.” This is not so terribly complicated, but apparently it is at least one degree too complicated for most commentators on economic matters–not just journalists, but professional economists. Why is it expounded only by a tiny minority of specialists (I know of only one, but there must be a few others)?
(Admittedly, there is a bit of complexity involving the phrase ‘ceteris paribus’. Things are interconnected, so if two situations differ in one respect–here, whether or not the Fed raises its target rate–they cannot be *exactly* the same in all other respects: some of the factors that play into a Fed decision must also have been different. But in the present case, as in many others, I think we understand the phrase well enough that explicit elucidation is not urgently required.)
7. May 2018 at 07:34
Rajat, I’m not sure why Williamson treats tightening as a negative supply shock, but in any case that’s not consistent with the empirical evidence on the response of asset prices to monetary shocks. Tight money tends to reduce TIPS spreads.
Thanks Julius.
Philo, It’s all about cognitive illusions. It seems like rising rates represent tight money.
7. May 2018 at 08:14
I think you’re right; the Fed won’t change its target while things are going well. I wish they would see the corollary though. That means that they will end up changing the target during a time when things are going poorly. Then they will delay making the change because they won’t want to look capricious and weak.
7. May 2018 at 17:53
testing
8. May 2018 at 01:40
[…] Considering the update to our recession probability track, which is based on Jonathan Wright’s 2006 paper describing a recession forecasting method using the level of the effective Federal Funds Rate and the spread between the yields of the 10-Year and 3-Month Constant Maturity U.S. Treasuries, we find that the spread between the 10-Year and the 3-Month Treasuries has slightly widened during the past few weeks, with the yield of the 10-Year rising faster than the yield of the 3-Month over that time. This change suggests that though the Fed is planning to hike short-term rates in the U.S. in about six weeks, it is presently doing so in an environment where the current stance of monetary policy would appear to still be expansionary. […]
8. May 2018 at 05:42
Somehow the NeoFisherians and Volcker having the sign wrong….
My posts in a spam filter?
11. May 2018 at 05:58
I’d be interested in hearing more about that Hoover conference. Is there a video/transcript available online?
11. May 2018 at 06:09
Answering my own question;
https://www.hoover.org/events/structural-foundations-monetary-policy-policy-conference