Neo-Fisherism in a world of multiple policy tools

Nick Rowe has another post criticizing the Neo-Fisherian claim that pegging nominal interest rates at a high level would raise inflation to a higher level.  Nick points out that in a model where interest rates are the central bank’s policy tool, the equilibrium is extremely unstable.

In my view the best way to see the problem with Neo-Fisherism is to first consider the situations where it is correct, and then ask what’s wrong with the actual claims being made.

In an earlier post I discussed the situation where Japan had a long-term trend rate of inflation of zero percent, and the US trend rate was 2%.  The BOJ wanted to raise their trend rate to 2%, at least in the long run.  How would a Neo-Fisherite do this?

One easy way is to simply peg the yen to the dollar.  Because PPP tends to hold in the ultra-long run (many decades), Japanese inflation would be expected to rise to 2% on average, although year-to-year changes might be rather erratic.  And because interest parity holds very well, even in the short run, Japanese interest rates would immediately rise to US levels.  BTW, to do this thought experiment right, you’d want to assume it was done in 2016, by which time US short-term rates will be higher than Japanese short-term rates.  You’d like Japanese interest rates to rise immediately.

Of course an immediate rise in short-term Japanese interest rates resulting from a change in monetary policy might be contractionary.  But the BOJ has multiple policy tools, and any contractionary impact can be offset by a suitable one-time depreciation in the yen, before it is permanently pegged to the dollar.  And BTW, if Japan wants 5% inflation they simply need to have a crawling peg, with the yen falling 3%/year against the dollar.

Can this work in a closed economy model, or is it simply a beggar-thy neighbor policy?  Yes, it can work in a closed economy model.  Instead of pegging the yen to the dollar, do a policy of pegging it to gold (or a basket of commodities), and then depreciating the currency by 2% per year against gold (or that basket.)  Now that would be a policy deserving of the name “Neo-Fisherian!”

Ironically, the basic problem with Neo-Fisherism is that it’s way too Keynesian.  The entire discussion is done using Keynesian assumptions—that control of interest rates is what we mean by “monetary policy.”  So when they talk about raising the interest rate peg to a higher level, people naturally assume that this is to be done in the way that Keynesians would raise interest rates, via tighter money.  But tighter money won’t raise the rate of inflation—hence the ridicule.  In fact, Neo-Fisherism is perfectly fine if they’d spell out that they plan to raise interest rates via easier money, as with an exchange rate peg, or a crawling commodity price peg.  Interest rates are only one of many possible policy tools, and in some ways the worst tool because the short-term effect of changes in M on interest rates is often the exact opposite of the long-term effect.  That’s what leads to the instability (or “fragility”) problem identified by Nick.

PS.  Switzerland adopted the policy discussed above just a few years back (depreciate the franc and then peg it to the euro at 1.2.)



24 Responses to “Neo-Fisherism in a world of multiple policy tools”

  1. Gravatar of Adam Platt Adam Platt
    25. November 2014 at 10:01

    “Instead of pegging the yen to the dollar, do a policy of pegging it to gold.”

    Whoa whoa whoa no… You were entirely right in talking about a peg to the dollar, which has a fairly good record of meeting the inflation target that the BOJ is seeking. Gold’s price is a very different story. It’s movements are highly erratic. A peg to gold over the last three years would have been disastrously deflationary, even with a crawling peg.

    I understand that this is just a mental exercise, and not a proposal on your part, but I strongly believe it’s time to leave gold out of the discussion altogether for the reason I mentioned above. Let’s leave it at “a basket of commodities”, though I’d go further and say “a basket of consumer goods”.

  2. Gravatar of Adam Platt Adam Platt
    25. November 2014 at 10:03

    Sorry I meant INflationary over the last three years, but DEflationary during the financial crisis, the worst possible time for deflation.

  3. Gravatar of Scott Sumner Scott Sumner
    25. November 2014 at 13:02

    Adam, Actually both a currency and a sliding gold peg are lousy policies, not at all recommended. But yes, gold is far worse. My point is that either would generate long term expected inflation.

  4. Gravatar of SG SG
    25. November 2014 at 13:05

    Neo-Fisherism does not reflect well on your profession, Scott.

  5. Gravatar of Adam Platt Adam Platt
    25. November 2014 at 13:16

    Gold price movements are so dramatic and unpredictable that I’m not even sure a sliding gold peg would necessarily generate long-term expected inflation. I’d concede that a sliding commodity-basket peg would though.

  6. Gravatar of Nick Rowe Nick Rowe
    25. November 2014 at 13:37

    Thanks Scott. But just a warning to everyone about my post: I messed up the math (as usual). Something’s wrong with it. I can’t get my intuition and math to line up properly. And my head’s not clear on it yet.

    But I like your way of thinking about it. Back to some or other variant of Fisher’s “compensated dollar Plan”, though it doesn’t have to be gold, of course.

  7. Gravatar of Scott Sumner Scott Sumner
    25. November 2014 at 13:49

    Thanks Nick.

    Adam, Of course you are right for all practical purposes–I was just making a theoretical point about inflation expectations. But it depends how long the long run is. Suppose I define it as 1000 years. 🙂

  8. Gravatar of Doug M Doug M
    25. November 2014 at 14:35

    Can someone distill what Draghi said yesterday? I gather he expressed a sentiment that Dr. Sumner has expressed, that the ECB has nearly limitless power to buy assets and inject money.

  9. Gravatar of Adam Platt Adam Platt
    25. November 2014 at 14:59

    Yes Scott, but in the “long run” we are all dead. Damnit, see what you did?! You made me quote Keynes on a Monetarist blog!

  10. Gravatar of benjamin cole benjamin cole
    25. November 2014 at 15:40

    Fascinating post. Still, Volcker did what Volcker did and it worked—while Reagan ran big deficits, operating and otherwise (contrary to what John Cochrane says).
    The big point is that inflation is not much of a worry, but sluggish growth is—so what is the monetary policy now?

  11. Gravatar of TravisV TravisV
    25. November 2014 at 17:44

    Prof. Sumner,

    What should I make of this new post and graph by Bob Murphy?

  12. Gravatar of EconByTheNumbers EconByTheNumbers
    25. November 2014 at 23:51

    “because interest parity holds very well, even in the short run, Japanese interest rates would immediately rise to US levels.”

    My understanding of the finance literature is _exactly_ the opposite. Uncovered interest parity doesn’t hold in the short run. And even in the long run it’s not rock solid.

    I’ll quote from a liberty street economics post to provide something of a source (

    “A pithy synopsis of this gargantuan literature is impossible, but the vast majority of studies that use only market data finds no support for this hypothesis and often uncovers a puzzle “” currencies for countries with higher bond yields tend to appreciate rather than depreciate. Also, forward discount quotes bear scant resemblance to realized depreciation rates, which implies either that premiums dwarf forward prices or that investors’ forecasts have been persistently wrong.”

  13. Gravatar of Ashton Ashton
    26. November 2014 at 00:20

    Another off topic question but I’ve been reading your stuff on the housing “bubble”. Your post on tight money causing the bubble due to the way American mortgages are structured is very persuasive.

    However, I’ve also read Josh Hendricksons post on Greespan adopting a de facto nominal income target of around 4.5pc. If that’s the case, where did the printing presses tighten? Did Greenspan mess up towards the end of his tenure, or did Bernanke cause it by not sticking to Greenspan’s regime? (Presumably through no fault of his own).

  14. Gravatar of Ashton Ashton
    26. November 2014 at 00:24

    Or, now that I think about it, did Bernanke passively cause it by allowing a shift in the velocity of money to occur without a shift in policy too?

  15. Gravatar of benjamin cole benjamin cole
    26. November 2014 at 06:00

    I think an MM consensus is the Fed tightened in 2008 due to oil shocks—when exactly the opposite response is indicated. On top of heavy leveraged property markets.

  16. Gravatar of ssumner ssumner
    26. November 2014 at 09:32

    Travis, I left a couple comments over there.

    Econbythenumbers, That’s true, but has no bearing on my claim here. I am talking about covered arbitrage.

    Ashton, I think that was Kevin Erdmann’s idea, but it is certainly a good hypothesis. Money was not all that tight in absolute terms, just compared to the 1960s-80s. Money got a bit tighter in late 2007, then much tighter in 2008.

    The recession that begin at the end of 2007 was not triggered by a fall in velocity, it was triggered by a slowdown in the growth rate of the MB. V actually rose.

  17. Gravatar of dtoh dtoh
    26. November 2014 at 13:28

    Further to your point Scott, I think (as I have noted before) that it’s important to distinguish between targets and tools. Asset purchases and fx trades are tools. Interest rates (except where the CB sets a rate directly, e.g. iOR) are not tools, they are targets.

  18. Gravatar of dlr dlr
    26. November 2014 at 14:11

    Cochrane’s latest has successfully advanced Neo-Fisherian policy to targeting the TIPS spread, as opposed to the level of nominal interest rates. This is a big step in the unification dance of NF and MM schools of monetary blogging. Both have now agreed that absolute interest rates may be poor instruments and indicators for monetary policy, and both now prefer directly using the relevant market forecast to enforce their favored nominal target. Conjoining the target and the instrument eliminates the Neo-Fisherian magical equilibrium problem, though some more cynical might argue that was its defining quality.

  19. Gravatar of Liberal Roman Liberal Roman
    26. November 2014 at 15:50

    OT: Has anyone seen the latest from Bill Gross here:

    Here is a sampler: “Currently, almost all central bankers have a targeted level of inflation that approaches 2%. Some even argue for higher levels now that deflationary demons approach in peripheral Euroland…And why, goes the argument, are lower prices so bad? Didn’t Wal-Mart get famous by featuring everyday low prices, and what’s so bad about 3-buck-a-gallon gas at the pump? More dollars in consumer pocketbooks suggests more spending, stronger growth rates and ultimately more jobs.”

    It continues like that as Gross bemoans our supposedly insane inflation rates. He repeats many of the same mantras you hear from the Austrians and RBCers.

    This amazes me. I now see that expertise in finance has ABSOLUTELY no correlation to understanding macroeconomics. None! What value do the masters of finance then bring? I know I sound a bit like Elizabeth Warren here but I seriously wonder what purpose they serve. They must serve some purpose because they command such high salaries. And since I am a believer in EMH, I can’t just dismiss them.

    The only thing I can come up with is Gross & investment bankers like him are glorified lawyers/accountants. Making sure all your i’s are dotted and t’s crossed when you invest. They certainly don’t “efficiently allocate capital”.

  20. Gravatar of Major.Freedom Major.Freedom
    26. November 2014 at 17:15

    Liberal Roman:

    Gross did not properly explain the connection between low prices and prosperity, and he did not “bemoan” price inflation in an Austrian way.

    What he did do was correctly indicate that there is nothing INHERENTLY wrong with low prices. That a central bank policy of 2% price inflation is flawed because it prejudicially condemns productivity based price deflation.

    Productivity based price deflation does not out any downward pressure on either profits or employment. It is the production and selling of more goods at lower prices.

    Business people understand that more often than academics, and certainly more often than blog posting commentators.

    You say “supposedly high inflation rates” as if there can be no questioning of price inflation.

    Did you know that the foundation for your suggestion that price inflation is not too high, would if you’re consistent be a “mantra” as well?

  21. Gravatar of Ben J Ben J
    27. November 2014 at 05:02


    “That a central bank policy of 2% price inflation is flawed because it prejudicially condemns productivity based price deflation.”

    What do you mean? Tech goods fall in price all the time. It’s fantastic. Not sure what the price of money has to do with that…

  22. Gravatar of Michael Byrnes Michael Byrnes
    27. November 2014 at 05:06

    Cochrane’s Neo-Fisherism seems to be getting closer to your kind of policy:

  23. Gravatar of ssumner ssumner
    28. November 2014 at 05:31

    dlr, I’ll take a look at Cochrane.

    Liberal Roman, That doesn’t sound too promising.

  24. Gravatar of Major.Freedom Major.Freedom
    29. November 2014 at 22:13

    Ben J:

    Now imagine most or all goods the productions of which would otherwise lead to falling unit prices across the board, I.e. the “price level” otherwise gradually falls.

    You can’t have general, economy wide productivity based price deflation with a central bank policy of 2% price level inflation.

    One industry (e.g. electronics) being so productive that the rate of increase in that industry’s supply outpaces the rate of increase in money and spending in that industry due to inflation of the money supply which is meant to cause aggregate prices to rise on average, is not a counter-claim to what I said earlier.

    On a related note, with a central bank policy of 2% price level inflation, if the prices of some goods, say electronics, fall on average, then there must be other prices that rise by MORE than 2% on average. That is a mathematical necessity.

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