Friday, August 26, 2016

We are All Neo-Fisherites

I was looking at this piece by Mark Thoma on increasing the inflation target. In some discussions of this issue, people seem to have a hard time getting to the core of the argument, but Mark does not. He has a good discussion of the Fisher effect, and his concluding paragraph is:
The Fed did not have enough room to cut interest rates before hitting the zero lower bound when the recession hit. Raising the target inflation rate, which would increase average interest rates and give the Fed more space for rate cuts, is something the Fed ought to seriously consider.
He's not quite as blunt as I might like, but he's saying that, if a central bank wants to hit a higher inflation target, it has to set nominal interest rates higher, on average. So, in the course of transitioning to a higher inflation target, the central bank must, at some time, have to raise nominal interest rates in order to produce higher inflation. But then, it must be true that, if the central bank has an inflation target of x%, and inflation is persistently y%, where y < x, then the central bank must raise its nominal interest rate target.

Monday, August 22, 2016

Danger!! Crazy Neo-Fisherians on the Loose!!

Not sure how I missed this Narayana post, but better late than never. I may not be Jacques Derrida, but a little deconstruction can be good fun. Here goes.

Opening paragraph:
Some economists argue that the Federal Reserve should take a highly unconventional approach to ending a long period of below-target inflation: Instead of keeping interest rates low to spur economic activity and push up prices, it should raise rates.
Clicking on "argue" takes you to my St. Louis Fed Regional Economist piece on neo-Fisherism. This is about as low-tech an elucidation of these ideas as I've been able to muster - it's got one equation, two figures, and 3,000 and some words. In any case, apparently I'm "some economists." John Cochrane is also well out of the Fisherian closet, and we have certainly received some sympathy from others (to whom the idea is obvious - as it should be), but neo-Fisherism is hardly a movement. As you can see, particularly in Narayana's post, there's plenty of hostile resistance.

The last sentence in the quote offers you a false choice. That choice is either a world of low interest rates, which obviously spurs economic activity and pushes up prices or the alternative: increases in interest rates which, the reader would naturally assume, would give us the opposite - less economic activity and lower inflation. The basic neo-Fisherian idea is that this is not the choice we're faced with. Let's put aside the issue of how monetary policy affects real economic activity, and focus on inflation. Neo-Fisherism says that conventional central banking wisdom is wrong. A lower nominal interest rate pushes inflation down, and no one should be surprised if an extended period of low nominal interest rates produces low inflation. Indeed, that's consistent with what we're seeing in the world right now.

Let's move on. Two paragraphs later, we have this claim:
Neo-Fisherites believe that modern economies are self-stabilizing.
I've been staring at that sentence for several minutes now, and I'm still not sure what it means, so I don't think I could "believe" it. But let's give this a try. In conventional Econ 101 macroeconomics, students are typically told that, in the short run, wages and prices are sticky, and there is a role for short-run "stabilization" policy, which corrects for the short-run inefficiencies caused by stickiness. The Econ 101 story is that, in the long run, prices and wages are perfectly flexible, and the inefficiencies go away. So, the standard story people are giving undergraduates is that modern economies are indeed self-stabilizing, but "in the long run we're all dead" as Keynes said. What's this have to do with neo-Fisherism? Nothing. Indeed, most conventional models have neo-Fisherian properties, whether those models have a role for short-term government intervention or not. In this post I worked through the neo-Fisherian characteristics of Narayana's favorite model, which is certainly not "self-stabilizing" in the short run. Bottom line: Basic neo-Fisherism is agnostic about the role for government intervention. It just says: Here's how to control inflation. You've been doing it wrong.

Narayana says that neo-Fisherism leads in the direction of "unusual policy recommendations."
Suppose, for example, the long-run equilibrium real rate is 2 percent. Neo-Fisherites would predict that if the Fed holds nominal rates at 0.5 percent for too long, people's inflation forecasts will eventually have to turn negative -- to minus 1.5 -- to get the real rate back to 2. Conversely, if the Fed raises its rate target to 4 percent and keeps it there, inflation expectations will rise to 2 percent. Because such expectations tend to be self-fulfilling, the result will be precisely the amount of inflation that the Fed is seeking to generate.
That doesn't describe "unusual policy recommendations" but is actually the prediction of a host of standard monetary models. For example, there is a class of representative agent monetary models (money in the utility function, cash in advance, for example) in which, if the subjective discount rate is .02, in a stationary environment, then the long run real interest rate is indeed 2%. In those models, it is certainly the case that a sustained nominal interest rate of 0.5%, supported by open market operations, transfers, whatever, must ultimately induce a deflation equal to -1.5%. Indeed, those models also tell us that deflation at -2% would be optimal - that's the Friedman rule. So, Narayana's thought experiment is not controversial in macroeconomics - that's the prediction of baseline monetary models. Things can get more interesting with fundamental models of money that build up a role for asset exchange from first priciples - e.g. overlapping generations models from back in the day, or Lagos-Wright constructs. New Keynesians seem to like taking the money out of models altogether, in "cashless" frameworks. NK models, and fundamental models of money typically have many equilibria, which presents some other problems. Multiple equilibria can also be a feature of cash-in-advance models. But, as I discuss in this post and this one, multiple equilibria need not be a serious problem for monetary policy, as we can design policies that give us unique equilibria - with Fisherian properties.

But, from Narayana's point of view, standard macroeconomics is not standard - it's crazy and dangerous. His claim:
Traditional economic models, by contrast, predict the opposite. If the central bank raises rates and credibly commits to keeping them high, people and businesses become less willing to borrow money to invest and spend. This undermines demand for goods and services, putting downward pressure on employment and prices. As a result, the economy can plunge into a deflationary spiral of the kind that afflicted the U.S. in the early 1930s.
What "traditional models" could he be talking about? This can't be some textbook IS/LM/Phillips curve construct, as he's discussing a dynamic process, and the textbook model is static. The only "tradition" I know of is a persistent narrative that you can find if you Google "deflationary spiral." Here's what Wikipedia says:
The Great Depression was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation. Whether deflationary spirals can actually occur is controversial, with its possibility being disputed by freshwater economists (including the Chicago school of economics) and Austrian School economists.
The closest thing to actual economic theory supporting the idea is Irving Fisher's debt-deflation paper from 1933. That's just another narrative - you won't find an equation or any data in Fisher's paper.

The best I can come up with in terms of a genuine theory of deflationary spirals, is what can happen in Narayana's NK model if inflation expectations are sufficiently sticky, and initial inflation expectations are sufficiently low - basically, people have to start off expecting a lot of deflation. Further, in order to support a "deflationary spiral," i.e. sustained deflation, conventional asset pricing tells us that there has to be sustained negative growth in output. But if there's a lower bound on output, which is natural in this type of environment, then the deflationary spiral isn't an equilibrium. Conclusion: Narayana has things turned around. Traditional macroeconomics gives us a long run Fisher effect. Deflationary spirals are not part of any "traditional" (i.e. serious) macroeconomic theory.

On the empirical front, the "deflationary spiral ... that afflicted the U.S. in the 1930s" looks like this:
There's a body of macroeconomic history that ascribes that deflationary episode to the workings of the gold standard. Indeed, the deflation stops at about the time the U.S. goes off the gold standard. Not sure why we're using a gold standard episode to think about how monetary policy works in the current context. In modern economies, I have no knowledge of an instance of anything consistent with Narayana's "traditional model" in which increases in nominal interest rates by the central bank cause a "deflationary spiral" (if you know of one, please let me know). But, when "deflation" enters the conversation, some people will mention Japan. Here's the CPI level for Japan for the last 20 years:
This is one of my favorite examples. We wouldn't really call that a "deflationary spiral" as the magnitude of the deflation isn't high at any time, and it's not sustained. Over 20 years, average inflation is about zero. Further, since mid-1995, the Bank of Japan's nominal policy interest rate has been close to zero, and recently the BOJ has thrown everything but the kitchen sink (except, of course, a higher policy rate) at this economy in an attempt to generate inflation at 2% per year - to no avail. Note in particular that the blip in inflation in 2014 can be attributed almost entirely to the direct effect of an increase in the consumption tax of 3 percentage points.

So, that's an instance in which a form of "traditional" macroeconomics doesn't work. That traditional macroeconomics is textbook IS-LM/Phillips curve with fixed inflation expectations. In that world, a low nominal interest rate makes output go up, and inflation goes up through a Phillips curve effect. A standard claim in world central banking circles is that a low nominal interest rate, sustained for a long enough time, will surely make inflation go up. I don't know about you, but if I want to catch a bus, and I go down to the bus stop and find someone who has been waiting for the bus for twenty years, my best guess is that sitting down in the bus shelter with that person has little chance of making a bus appear any time soon.

Next, in Narayana's post, he shows a time series plot of the fed funds rate and a breakeven rate. To be thorough, I'll include other breakeven rates, and focus on the post-2010 period, as the earlier information isn't relevant:
Narayana says:
The Fed held the nominal interest rate near zero from late 2008 until late 2015 -- a policy that, according to Neo-Fisherites, should have driven inflation expectations into negative territory. Yet they stayed roughly the same for most of that period. They started to slide downward only after the Fed began to tighten policy in May 2013 by signaling that it would pull back on the bond purchases known as quantitative easing. Also, the recent modest increase in the nominal rate has not led to a commensurate increase in inflation expectations.
"According to Neo-Fisherites?" No way! Any good neo-Fisherite understands something about low real interest rates, and what might cause them to be low. Here's me thinking about it in 2010. If there are forces pushing down the real interest rate, we'll tend to get more inflation with a low nominal interest rate than we might have expected if we were thinking the long run real rate was 2%, for example. So, by 2013, yours truly neo-Fisherite was certainly not surprised to be seeing the breakeven rates in the last chart.

But how should we interpret the movements in the breakeven rates in the chart? On one hand, breakeven rates have to be taken with a grain of salt as measures of inflation expectations. They can reflect changes in the relative liquidity premia on nominal Treasury bonds and TIPS; they're measuring breakeven rates for CPI inflation, not the Fed's preferred PCE inflation measure; when inflation falls below zero, the inflation compensation on TIPS is zero; there is risk to worry about. On the other hand, what else can we do? There are alternative market-based measures of inflation expectations, but it's not clear they are any better than what I've shown in the chart.

So, suppose we take the breakeven measures in the chart seriously. The 5-year and 10-year breakevens can be interpreted as predictions of average inflation over the next 5 years, and the next 10 years, respectively. The five year/five year forward rate can be interpreted as the average inflation rate anticipated over a five-year period that is 5 to 10 years from today. Given that the interest rate Narayana is focused on here is the overnight fed funds rate, what matters for these market inflation expectation measures is the course of monetary policy for up to the next 10 years - in principle, the structure of the Fed's policy rule over that whole period. There are plenty of other things that matter as well - world events, shocks to the economy, and how those events and shocks matter for the Fed's policy rule. Narayana seems to think that the Fed "tightened" in May 2013, but I remember that episode - the "taper tantrum" - as a prelude to a period in which the public perception of the future course of interest rate hikes was constantly being revised down. A downward path for long-term inflation expectations seems to me consistent with a neo-Fisherian view of the world, with the market putting increasing weight on the possibility that nominal interest rates and inflation will remain persistently low.

Narayana finishes off in true hyperbolic fashion by raising the twin specters of the Great Depression and Great Recession:
I, too, once believed that the horrific events of the early 1930s, when economic output fell by a quarter and prices by even more, could not recur in a modern capitalist economy like the U.S. Then 2008 happened, and we all learned where a religious belief in the self-correcting nature of markets can lead us. If we want stability, we have to choose the right policies. Raising rates in the face of low inflation is not one of them.
I hope you understand by now that I think: (i) economics is about science, not religion; (ii) neo-Fisherism has nothing to do with the "self-correcting nature of markets." Do I think that Narayana's policy prescriptions are crazy and dangerous? Absolutely not. If he's right, which I think he's not, then good for him. If he's wrong, and his policies get implemented, what harm gets done? Inflation stays low, and central banks may proceed to demonstrate, through experimentation, that unconventional policies don't do much. Or maybe we find some that actually work. Who knows? We would really be in danger if the people who think of high inflation as a cure-all figure out how to produce it. But I don't think that will happen.