Heretics

Low inflation is back in the news.  The Wall Street Journal covers the latest decline in European inflation. Peter Schiff has a nice article explaining that inflation is not such a great thing, unless of course you're a government that wants to pay back debt with cheap money. I dipped into this heresy in an earlier post, explaining that maybe zero rates and slight deflation just represent the arrival of Milton Friedman's optimal quantity of money.

But this news also brings to mind some thoughts on the second heresy -- maybe we have the sign wrong, and we're getting low inflation or deflation because interest rates are pegged at zero, and maybe the way to raise inflation (if you want to) is for the Fed to raise interest rates, and leave them there. (Earlier posts on this question  here and here)

Back in 2010, Narayana Kocherlakota explained the basic idea

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent, but low, levels of deflation.”

It's really simple. One of the most fundamental relations in economics is the Fisher equation, nominal interest rate = real interest rate plus expected inflation. Real interest rates can be affected by monetary policy in the short run. But not forever. So if the Fed raises the nominal interest rate and leaves it there, expected inflation should eventually rise to meed that nominal rate.


In conventional thinking, no. There is an instability in the system in conventional thinking, so that raising the nominal rate raises the real rate, sends output down and inflation declining. While the equation is a "steady state" it's an "unstable" one.  So, interest rates have to be like a sheep dog corralling sheep -- go way off to the right to move them left, then go way off to the left to move them right, and so on.

Well, maybe not. Maybe it's more like "Babe" and just calmly heading for the pen will work.

Stephanie Schmitt-Grohé and Martín Uribe's  The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery is a new paper investigating to this point. They study a pretty complicated model, with employment dynamics, sticky wages, and long-run expectations. But the bottom line is interesting.

The paper... shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment

Here is the central figure making the point. The solid lines are the model's dynamics replicating where we are now. The dashed line shows what they think would happen if the Fed were to peg the interest rate at 6% and leave it there.

Source: Stephanie Schmitt-Grohé and Martín Uribe

In the model (as I understand it, which is not well) the basic problem is that long-run inflation expectations can get stuck too low, or revert back to a higher level. By pegging the interest rate at a higher level and just leaving it there, the Fed communicates that expected inflation had better rise in the Fisher equation. 

This may be a case of the difference of new vs. old Keynesian models. The unstable intuition is how Friedman's 1968 address and old style Keynesian models work, because expectations are backward looking. In new Keyensian models, if the Fed can change expected inflation -- by, in this case, a rock-solid peg -- then interest rates can rise quickly and actual inflation will adjust to expected inflation. 

(If commenters understand the story behind Stephanie and Martín's graph and equations better than that, post away!)