Monday, May 21, 2018

Inflation, Interest Rates, and Neo-Fisherism In Turkey

In most respects, President Erdogan of Turkey is not known for his progressive instincts, but in economic policy he may be the only convinced Neo-Fisherite on the planet who potentially has any power over monetary policy decisions. Erdogan has been at odds with the Central Bank of Turkey, and seems intent on changing the Bank's approach to inflation policy. In a recent interview in the UK, and recent speeches, Erdogan has made clear that he thinks that high nominal interest rates are the cause of high inflation in Turkey, and that disinflation can be achieved if the Central Bank reduces its policy rate.

Erdogan's views have been derided by market participants, and some panic ensued, manifested in a depreciation in the Turkish currency. But, apparently Erdogan's ideas aren't coming out of thin air, as his economic advisor Cemil Ertem has written a defense of Erdogan's views, which does a good job of finding the relevant supporting evidence. He cites John Cochrane's work, and speeches by central bankers, including Jim Bullard, that support neo-Fisherite ideas.

So, what's been going on in Turkey? Here's the time series of CPI inflation rates:
Turkey had very high inflation from the early 1980s until 2002, with the inflation rate sometimes exceeding 100% per annum. But, there was a large disinflation, with the inflation rate falling from a peak of 73% in 2002 to 7% in 2004. Since 2004, inflation has been much lower than over the previous 20 years, and much more stable. However, if we compare the path of recent inflation in Turkey with the United States, the picture looks like this:
So, inflation in Turkey is still considerably higher than in the United Stages, averaging about 8% since 2004, and it has recently been creeping up above 10%. Further, the Turkish central bank has had inflation targets that it has been persistently overshooting for more than 10 years:

What has the Turkish central bank been doing, and what does it propose to do in an attempt to hit its inflation target? From the central bank's most recent Inflation Report:
Given a tight policy stance that focuses on bringing inflation down, inflation is projected to converge gradually to the 5-percent target...
...the disinflation process will continue in 2018 due to the decisive implementation of the tight monetary policy and convergence of economic activity and loan growth to a milder growth path.
So, that seems like boilerplate central banking. "Tight" monetary policy, i.e. a high nominal interest rate target, will lower inflation, and this disinflationary process will get some help from the Phillips curve, i.e. "a milder growth path" will reduce inflation, according to the central bank.

This is the Turkish central bank's inflation forecast:
So, in a little over two years' time, the central bank thinks it will have inflation down to its 5% target. Of course, that's what it thought in 2016:
In contrast to that optimistic forecast, inflation went up, not down, in the intervening period, and is currently well outside what was denoted the "forecast range" in the 2016 forecast.

So, you might conclude that the Turkish central bank is not capable of reducing inflation. But that's a puzzler. A central bank that could reduce inflation by about 66 percentage points in a two-year period from 2002 to 2004 can't get inflation down from 7% to 5% from 2016 to 2018? What's that about? Well, what did the central bank do to produce the 2002-2004 disinflation? Let's look at the path for short-term interest rates and inflation over the same period as in the first chart. Here I'm using an overnight interbank nominal interest rate (the only short-term interest rate I could find for Turkey - if you know where to find other interest rate data, please let me know):
So, in that chart we're seeing a typical Fisher effect - higher inflation is associated with higher nominal interest rates. The spikes in the overnight rate occurred during 1994 and 2001 financial crises in Turkey. Next, let's focus on the disinflationary period and after:
As we all know, if central banks can do nothing else, they are at least capable of pegging short-term interest rates. So, the path we see in the above chart for the overnight rate was determined by the central bank of Turkey. Did the central bank engineer a disinflation by keeping the nominal interest rate high? No. Monetary policy acted to reduce short-term nominal interest rates, and the inflation rate fell.

I'd say President Erdogan isn't as nutty as people are making him out to be - at least in the inflation policy realm. And Turkey is a very interesting example, as it appears to be following the orthodox central banking rulebook: Phillips curve, Taylor rule. There are plenty of countries - Japan being the most extreme - where inflation has been chronically below central bankers' inflation targets, so if Turkey is following the standard rulebook, why is inflation chronically above the inflation target there? Well, that's exactly what mainstream theory predicts. A central banker who blindly follows a Taylor rule (with the Taylor principle in place - more than one-for-one response of the nominal interest rate to changes in inflation) reduces the nominal interest rate target when inflation is low, believing that this will increase inflation, but inflation falls, and the central banker gets stuck in a low-inflation policy trap. Similarly, a Taylor rule central banker who sees high inflation increases the nominal interest rate target, believing that this reduces inflation, but inflation goes up. If the central banker followed the Taylor rule blindly, then inflation would increase indefinitely. But in Turkey's case that may not happen, even without President Erdogan in the mix, due to public resistance to higher interest rates.

There's a lesson here for countries like Canada and the United States, where central bankers are currently hitting their inflation targets. The Bank of Canada and the Fed avoided becoming Japan - falling into the low-inflation policy trap - because they either kept nominal interest rates off zero (Canada), or lifted off from zero (US). But interest rate hikes can be overdone - the risk as that you become Turkey.

Wednesday, May 9, 2018

Natural Rates

The natural rate of unemployment is not something we hear a lot about in academic circles these days, and it's out of fashion even in some central banks. I was out of town when this happened, but when I was working for the St. Louis Fed, Larry Meyer showed up at the Fed to talk to economists in the Research Department. One of things he wanted to know was our estimate of the natural rate of unemployment. Meyer seemed offended, apparently, that we had never thought about it. He didn't know that it's hard to find anyone at the St. Louis Fed who would take the Phillips curve, let alone the natural rate of anything, seriously.

I was reading Paul Krugman's blog, and he is saying that recent evidence "seems to have brought skepticism about the natural rate to critical mass." That sounds promising, so I thought I would like to understand what Krugman is getting at.

Krugman thinks that the "natural rate hypothesis," which he attributes to Milton Friedman, was an influential idea that we should re-assess. So, what did Friedman actually have to say about this? If you read Friedman's "The Role of Monetary Policy," you'll find that the natural rate hypothesis is no more nor less than the long-run neutrality of money. Friedman argued that the central bank could control nominal quantities - the nominal quantity of central bank liabilties outstanding, the price level, inflation, for example - but that it would fail in any attempt to permanently control real magnitudes. To get that idea across, Friedman told a story. That is, there exists a natural rate of unemployment - roughly, the rate of unemployment that would exist in the long run in the absence of aggregate shocks - and if the central bank endeavors to force the unemployment rate to be higher or lower than the natural rate then this would lead to ever-decreasing or ever-increasing inflation, respectively (though in the ever-decreasing case, presumably there would be a lower bound due to the lower bound on the nominal interest rate). A key part of the story is a theory of the short-run nonneutrality of money. For Friedman, this is a theory of money surprises, relying on adaptive expectations. Workers supply labor based on the real wage they expect, so if higher-than-anticipated money growth causes growth in nominal wages and prices to exceed what is expected, then workers supply more labor, thinking their real wage is higher, and firms hire more labor, as they know that real wages have fallen. That's a theory of Phillips curve correlations. Money surprises cause output and inflation to move in the same direction.

Lucas constructed a closely related theory of money surprises and nonneutrality, and in the process introduced rational expectations to the macro profession. Lucas has a theory of Phillips curve correlations, and can also say something about how the Phillips curve shifts with the monetary policy rule. For example, the slope of the curve changes with the degree of noise in the policy rule. New Keynesian (NK) models can of course produce Phillips curve correlations as the result of sticky prices. Expectations are rational in such models (the baseline ones anyway), and there is no imperfect information about aggregate shocks, but monetary policy is not neutral because some prices are locked in from past decisions. Unanticipated monetary expansions then lower relative prices for firms which cannot change prices in the current period, and those firms increase output to meet demand.

In principle all these Phillips curve models - Friedman, Lucas, NK - can give rise to the process Friedman describes, i.e. a process by which monetary policy can mess things up when the central bank attempts to peg real quantities. In NK models this would require some work. But the idea might be to have pricing rules respond to observed central bank behavior. The central bank tries to peg the path for aggregate output, but then firms change their pricing behavior in response, and this leads to either increasing or decreasing inflation.

In any case, I cannot find any evidence in Friedman's work that he thought measuring the natural rate of unemployment would be a useful thing to do, or that shocks independent of monetary policy causing movements in the unemployment rate would necessarily lead to movements in the inflation rate in the opposite direction. So those ideas are coming from somewhere else, and they are well-entrenched in the thinking of central bankers. Paul Krugman believes this too, as he says:
I’d say that the preponderance of evidence still supports the notion that high unemployment depresses inflation, low unemployment fosters inflation.
That's a particularly poor way to think about inflation. As David Andolfatto likes to tell us, unemployment does not cause inflation. Some shocks to the economy cause unemployment and inflation to move in opposite directions, for example in the Spanish example that Krugman shows us in his post. In other cases - for example during most of the post-2009 period in the United States - inflation and unemployment move in the same direction, more often than not.

Further, the prevalent idea in central banks currently is that, once the unemployment rate falls below the natural rate, inflation will take off. This idea is built on a misunderstanding of Friedman's thought experiment in his 1968 paper. The results of a monetary policy experiment don't tell us how inflation responds to other types of shocks that could be moving the unemployment rate around.

Saturday, May 5, 2018

Neo Fisherism: Look, it Works!

We know that Neo-Fisherism works in our models. In baseline macroeconomic models in which money is neutral, increases in inflation and increases in nominal interest rates go hand-in-hand. If we incorporate standard types of frictions that give rise to monetary non-neutralities in our models, for example New Keynesian sticky prices or segmented markets, an increase in the central bank's nominal interest rate target will in general raise inflation - in the short run and in the long run. See for example Cochrane (2016), Rupert and Sustek (2016), and Williamson (2018). And note that these theoretical predictions don't come from some freakish concoction of a demented neo-Fisherian, but from the mainstream modern macroeconomic models widely used by academics and central bankers.

But these predictions run afoul of standard central banking practice. I have yet to meet a policymaking central banker who thinks that inflation goes up if the central bank "tightens," in the usual sense in which that word is used. Standard central banking practice is of course enshrined in basic Taylor rules, which dictate increases in the central bank's nominal interest rate target when the inflation rate increases. In fact, the "Taylor principle" implies a more-than-one-for-one increase in the nominal interest rate target in response to an increase in the inflation rate.

Standard theory is pessimistic about the ability of a Taylor-rule central banker to successfully control inflation. Given a fixed inflation target, the Taylor-rule central banker can get stuck in a policy trap in which the nominal interest rate is as low as the central banker wants it to go, inflation is lower than the inflation target, and low inflation continues in perpetuity. But apparently real-world central bankers don't follow a rigid Taylor rule. For example, central bankers in the United States and Canada have recently raised their interest rate targets in the face of inflation that was falling below the inflation target. The Fed and the Bank of Canada, in their public statements, have both used what an Incipient Inflation Argument (IIA) in order to extract themselves from the low-inflation policy trap. That is - as they argue - inflation may not be high today, but given a tightening labor market, the Phillips curve will surely reassert itself, and we have to get ahead of the curve. If we don't get ahead of the curve then, as the argument goes, we'll have to tighten at a higher rate later on, with dire consequences.

The IIA allows the central banker to do the right thing - the neo-Fisherian thing, basically - while not abandoning the Phillips curve in some obvious way. To quote yours truly from September 2015:
What are we to conclude? Central banks are not forced to adopt ZIRP [zero interest rate policy], or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world's central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target - zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require "tightening" in the face of low inflation.
At the time, there was no shortage of opinion to the contrary. As Larry Summers wrote in the Washington Post in August 2015:
The Fed, like most central banks, has operationalized price stability in terms of a 2 percent inflation target. The dominant risk of missing this target is to the downside — a risk that would be exacerbated by tightening policy.

In December 2015, as you may recall, the Fed in fact began tightening in the face of low inflation. Here's what happened:
So much for downside risk. It took a while, but raising the Fed's nominal interest rate target coincided with an increase in inflation, to the point where the Fed has now hit its 2% PCE inflation target. So, the Fed's policy moves have been a success, and those who feared that interest rate hikes would take the US economy over a cliff should have calmed down and slept more soundly. After six 25-basis-point increases in the fed funds rate target range, the unemployment rate has fallen from 5.0% to 3.9%.

Should central bankers just declare neo-Fisherism a success, throw away their Phillips curves, and move on? Phillips curves should have of course been thrown out long ago, but we want more evidence to convince people that changing the sign in the policy rule (increasing the nominal interest rate target when inflation is below target) is the right thing to do. The recent US experience is only one episode, and there are many factors other than monetary policy (oil prices, factors affecting the real rate of interest) that affect inflation over the short term and the long term.

What has happened in other countries over this same period (2012 to present)? Here's Canada:
The Bank of Canada has a 2% inflation target, in a range of 1-3%, so as you can see the Bank has not been outside its target range much in the last six years. Average inflation has been below 2%, but the current inflation rate in Canada is currently at 2.3%. In terms of interest rate hikes, the Bank is one behind the Fed, with its target rate at 1.25%, as compared to the ON-RRP rate in the US (the comparable secured overnight rate), which is pegged at 1.5%. The Bank of Canada was one of the first central banks in rich countries to increase its policy rate after the financial crisis, though the interest rate target dropped after the fall in oil prices (associated with a drop in real activity in Canada). Overall, inflation performance in Canada relative to the US is consistent with neo-Fisherism. After the financial crisis, the Bank of Canada didn't set its nominal interest rate target as low for so long as did the Fed, and inflation has been on average somewhat higher in Canada.

In most of the other rich countries in the world, central banks have kept their nominal interest rate targets close to zero or below zero for a considerable time. I've selected five key ones: the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Japan, and the Swedish Central Bank. Here are the inflation time series (from 2012) in those countries:
In this picture, the UK stands out as having inflation above the 2% Bank of England inflation target for more than a year. Of course the Pound has also depreciated by about 20% against the US dollar since 2014, for reasons having little to do with monetary policy. In Sweden and the Euro Area, inflation has at times been at the 2% target, though inflation is now softening in those jurisdictions, particularly in the Euro area. Inflation has come up in Switzerland and Japan, but is still well short of 2% in both countries. As well, we could look at a scatter plot of inflation vs. the overnight nominal interest rate in each of the seven countries we have been looking at:
So, that's a nice neo-Fisherian picture. If good labor market performance produces high inflation, why is inflation so much lower in Japan and Switzerland than in Canada? If unconventional monetary policies make inflation go up, why are the countries with the most extreme unconventional policies (negative nominal interest rates, quantitative easing) - Japan, Switzerland, and the Euro area - the ones with the lowest inflation in the picture? Canada, which didn't indulge in any unconventional policies, but has a higher short-term nominal interest rate than all these countries but the US, has an inflation rate of 2.3%. How come? Neo-Fisherite policy works, that's why.

But I think (in part because I've been told) that central bankers are skeptical that they could ever sell a neo-Fisherite monetary policy rule to the public. No one gets excited about higher interest rates, and the average layperson has been conditioned by decades of central banker dialogue about heating the economy up, cooling it down, taking away the punch bowl, etc. It's much easier to swallow higher interest rates if your neighborhood central banker is telling you that this keeps the economy from overheating. We know what happens when things overheat. They break down and explode. In some theories (New Keynesian models, old money surprise models) you can have too much output, but in practice I think this is nonsense. The unemployment rate can't be too low, unless there's some long-run inefficiency at work. The overheating economy is simply part of the IIA argument. That is, a tight labor market is excellent cover for interest rate hikes, which are going to bring inflation up to target. Jim Bullard likes to say: "tighten on good news."

So what's the harm in using the IIA argument, if it's just carrying out the neo-Fisherite program in a more palatable way? First, there are circumstances in which it would be optimal to increase inflation, even if real activity is sub-par. The right thing to do could be to raise the interest rate target, but if the economy isn't "heating up," the IIA argument can't be used. Second, central bankers can run through the story so many times that they believe it. In current circumstances, the risk is that central bankers end up exceeding their inflation targets because of a misunderstanding of the effects of their policies. For example, officials at the Bank of Canada and the Fed think of their current policy settings as "accommodative." From the April 18 Bank of Canada statement:
Inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past 12 months. That said, interest rates remain very low relative to historical experience. This is because the economy is not yet able to remain at full capacity on its own.
And from the May 2 FOMC statement:
The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.
Policymakers at the Bank of Canada and the Fed think in very similar ways. In both places, policymakers think of policy in terms of a neutral nominal rate of interest (NNRI) which is thought to be in the range of 2.5-3.5%. According to their thinking, if the central bank's nominal interest rate target is less than the neutral rate, this puts upward pressure on the inflation rate and downward pressure on the unemployment rate. So, the ultimate goal is to raise the nominal interest rate to the NNRI, at which point the economy will be operating at potential and inflation will be at its target.

The key problem with this reasoning is that, if the central bank holds the nominal interest rate constant for a long time, policy ceases to be "tight" or "loose." For example, if the Bank of Canada had pegged its interest rate target to 2% in 2009 and kept it there, real economic activity in Canada today would be indistinguishable from what we're seeing. But inflation would be higher. In Canada and the US, nominal interest rates have been low for going on 10 years, and those interest rates are moving up. So the Bank of Canada and the Fed aren't removing accommodation - they're tightening. And tightening means a negative effect on real economic activity and a positive effect on inflation. The Bank of Canada is achieving its goals. The Fed is achieving its goals. Time to stop tightening.