Monday, October 19, 2015

Do higher interest rates raise or lower inflation?

A new working paper by that title (pdf).  Some of the main ideas are in a longish post from last August.

The fact that inflation is so stable when interest rates are stuck at zero has profound implications. If inflation is stable at a zero peg, it must be stable at a higher peg as well, which means raising interest rates must sooner or later raise inflation. The open question, which this paper goes after, is whether inflation can temporarily decline when interest rates rise. (Graphs from an earlier blog post here.)

Classical "Keynesian" or "Monetarist" models say that inflation is unstable in a peg. They must be wrong. "New-Keynesian" models say that inflation is stable in a peg, a good point in their favor. The important difference is rational expectations. If people drive a car looking in the rear view mirror, cars are unstable and veer off the road. If people look forward, then cars are stable and get back on the road on their own.

But the standard new-Keynesian model also predicts that inflation goes up if interest rates rise, as shown in the graph.  Interest rates are blue, inflation is red, output is black. The dashed line is when people know the rise is coming, the solid line for when it's a surprise.  Raising rates does lower output, just as you thought.

The paper tries everything to revive the idea that higher interest rates lower inflation, without luck.

The standard new-Keynesian model accounts well for the fact that inflation has been stable at a zero interest rate peg. However, If the Fed raises nominal interest rates, the same model model predicts that inflation will smoothly rise, both in the short run and long run. This paper presents a series of failed attempts to escape this prediction. Sticky prices, money, backward-looking Phillips curves, alternative equilibrium selection rules, and active Taylor rules do not convincingly overturn the result. The evidence for lower inflation is weak. Perhaps both theory and data are trying to tell us that, when conditions including adequate fiscal-monetary coordination operate, pegs can be stable and inflation responds positively to nominal interest rate increases.


  1. " The dashed line is when people know the rise is coming, the solid line for when it's a surprise."

    People seem to have been expecting a rate rise is just around the corner for the last year or so, but no inflation has been seen. So doesn't that present a problem for the model?

  2. There seems to be a typo ("?") on the right-hand side of the three-line equation at the top of page 76.

    1. it's intentional, meaning lets check if the two sides are equal. I'll clarify.
      You made it through this dense paper to the appendix in 27 minutes flat? I'm amazed.

    2. John,

      "The paper tries everything to revive the idea that higher interest rates lower inflation, without luck."

      Try harder. Start with something simple - there are more bonds outstanding than there is money in circulation. All people trade in their money for bonds at once - what happens to the inflation rate?

      Or how about, central bank is the only bank in existence. All loans are made and retained by the central bank (Citigroup, JP Morgan, etc. do not exist). Total loans outstanding are growing 3% a year, annual interest payments (to the central bank) are 3% a year. With the inflation rate rise or fall as interest payments to the central bank are increased while loan growth remains the same.

      Of course, you may just be commenting on the state of the U. S. economy right now, but it is not that hard to imagine a scenario where having the central bank raising the nominal interest rate it lends at will lead to a lower inflation rate.

  3. Before I read the paper, I want to know if you are making an reductio ad absurdum argument.

    I "know" that tighter central bank policy will lower the inflation rate.

    So, do I need to revise my priors, or do I need to reject NK type models?

    Could any econometric tests or case studies illuminate the controversy?

  4. ". If inflation is stable at a zero peg, "

    John: what are you talking about? We don't have a zero peg. We have a Fed that is just itching to raise rates at the earliest possible moment and everyone knows it. If the Fed announced, "we will create as much money as needed to hold the Fed Funds rate at zero no matter what happens with inflation or NGDP growth", you'd find inflation would be a bit less stable.

    1. Good point. We do have a zero peg in the downward direction at least. I'll be more careful on language.

    2. Kenneth & John, you may find this post interesting (addressing Ken's comment here, and John's paper).

  5. When I was much younger than I am now, in a previous millennium, I attended the University of Chicago. While so matriculated, I took the required course in elementary economics and political theory Called Social Science I. As part of that course, Mr. Friedman gave lectures on Money. He said that inflation is everywhere and at all times a monetary phenomenon. And, I believed him.

    Many years later I read a book by an eminent historian, "The Great Wave: Price Revolutions and the Rhythm of History" by David Hackett Fischer (OUP, 1996)

    The book argues that inflation is caused by underlying demographic and technological changes. The book is not well regarded by economists as the author is not a guild member. But, it seems to me after the last couple of decades, the current lack of inflation is better explained by Fischer's book, than by economic modeling.

    1. The post is about an economic model that does explain the current lack of inflation.

    2. "The post is about an economic model that does explain the current lack of inflation."

      I confess I am a bit confused - from what I read (blogs, news pieces etc), I thought the lack of inflation is because banks are hoarding all those excess reserves at the Fed, and not putting it in circulation via loans. Is this position wrong?

    3. "The post is about an economic model that does explain the current lack of inflation. "

      I'm wondering if the motivation for this modeling is to cast some doubt upon public opining that is based in part on Keynesian models and ideas.

      But as I understand it, the public arguments are based as much on evidence from empirical data as on theoretical (modeling) exercises.

    4. I wrote: "the current lack of inflation is better explained by Fischer's book, than by economic modeling."

      JC replied: "The post is about an economic model that does explain the current lack of inflation."

      To which I respond: I understand that you posted about a model that purports to explain the current lack of inflation. I, however, am not persuaded that any economic model explains this phenomenon. I think that the better explanation is given by the book noted above.

  6. I like this very paper very much. I only have one concern. On page 47, you write ""equation (16) shows how to construct the Taylor rule assumption that generates any desired equilibrium. The fact that adding a Taylor rule, by itself, doesn't help us at all to choose an equilibria." I agree that the Werning construction method is useful in finding pairs \phi_{\pi} and i^\hat that support particular equilibrium sequences for inflation and interest rates.

    But, if one can go out and _measure_ the central bank's \phi_{\pi} and i^{\hat} and the central bank satisfies the Taylor principle, then one should observe one of the equilibria that you plot on page 37. Indeterminacy is no longer an issue once the central bank picks a particular Taylor coefficient and i|hat. For an empirically observed values of \phi_{\pi} and i^{\hat}, it may very well be the case that the unique equilibrium has the feature of "E" in Figure 14, i.e. inflation goes negative on impact.

    My comment does not imply that the long-run Fisherian relationship does not hold. I observe that all of the equilibria in the top panel of Figure 14 converge to a new higher inflation rate. On this longer-run relationship, I think you are on firmer ground.

    All of this being said, I think the paper is very nice.

  7. Nice unintuitive paper, I'm glad that you take this topic seriously. (pg 63:"observation")

    I'd fill out the debt portion, IMHO. Interest rates are nothing but the price of borrowing, i.e. the supply of healthy balance sheet versus savings demand.

    The government debt market is a small portion of the overall debt markets. If the price of debt is high (rates low), then there are not enough strong balance sheets (that can take additional leverage) versus the number of prospective savers.

    Debt is deflationary -- inflation has been stable at zero rates because the economy is already so highly leveraged (preexisting deflation pressures). As long as the debt survives, inflation will be suppressed and monetary policy will be seemingly ineffective. Boosting interest rates will have both supply consequences for balance sheets (inability to roll over debt = default); and demand consequences (you dont save in "certificates of confiscation").

    When savings demand rushes out of fixed income and into other stores of wealth; and supply begins to get constrained by failing firms, you just might get higher monetary velocity & inflation.

  8. Where and how would you attribute the impact of regulation (Basel III, Dodd-Frank etc) here? Lending and borrowing in the market today are skewed; Governments, Apple and Verizon can borrow billions without batting an eyelid but the lowly rated SMEs and individuals cannot.

    For them, credit is still tight; and effective rates are still high.

  9. Can the Fed freeze the Fed funds rate or IOER and conduct QE without inflationary effect?

    If a nation restricts the supply of housing (30% of inflation), and there is economic growth, is some inflation inevitable or will freezing interest rates also freeze rents, even if demand exceeds supply?

  10. Prof Cochrane, thanks for the paper. How interest rate reflect on asset prices? Low rates - stable asset prices? Or not? ATB

  11. I'm skeptical about the starting premise of this study - that the stability of inflation during a prolonged period in which the overnight target for the federal funds rate was zero to 25bp overturns the longstanding claim that inflation must be unstable under an exchange rate peg. While the overnight rate was held stable at zero throughout this period, monetary policy was not pegged from 2008 to the present – far from it, the Fed innovated further easing via forward guidance and QE, both of which were intended to put downward pressure on longer term interest rates. Shadow fed funds measures like Wu-Xia attempt to map this back into fed funds equivalent space. If the Fed had given up when rates hit zero I suspect inflation would indeed have been unstable (to the downside). As a previous respondent noted, we were not in a pegged regime to the upside during this period either, as the FOMC communicated its expectation to eventually normalize policy.
    Why should we not read the evidence instead as consistent with the view that the stability of inflation derived from the ongoing adjustment of the stance of monetary policy even after the overnight rate hit the zero bound?

  12. There is not a single central bank in the world that operates under the premise of permanent pegs or pegs that do not respond forcefully to inflation. So this is all nice theory but not relevant.

  13. Prof. Cochrane,

    I'm reading your paper and something strikes me.
    Please correct me if necessary.
    Figure 2 represents the standard IRF of a transitory shock (mean reverting) on interest rate, in the standard NK model. Then, how do you explain the fact your IRF (regarding inflation dynamics) is at odds with the one in Gali's textbook (2008, p. 53), given that you're using the very same NK model?

    1. I only have the new edition, and he doesn't do responses to monetary policy shocks with an interest rate rule. I would bet however that he adds a Taylor rule with mean-reverting shocks, thus gets a result with the jump to a lower equilibrium. See also p. 14 and Figure B1 here

    2. Thanks for your answer !
      Best regards.

  14. Is this result in agreement with the Friedman Rule of having a zero nominal interest rate peg is an optimal policy?
    If so, why do you say "classical Monetarism assumes interest rates peg are unstable".

  15. Dr. Cochrane,

    In the linked paper you wrote:"Most theories contain the Fisher relation that the nominal interest rate equals the real rate plus expected inflation,
    it = rt + Et{pi}t+1
    , so they contain a steady state in which higher interest rates correspond to higher inflation."

    Is that correct? One can see that if expected inflation increases or the real interest rate increases then nominal interest rates should increase but does this equation demand that the reverse be true? If A is true then B is true, A is true therefore B is true but that does not mean that if B is true that A is true.

  16. all for unconventional wisdomApril 1, 2016 at 2:02 AM

    Very, very interesting food for thought.

    I am wondering how the Volker era fits into this? In the late '70's, I always felt that Volker's high interest rates were causing, not quashing, high inflation.

    I saw the Reagan/Greenspan decision to loosen things and lower interest rates then having an instant impact, lowering all sorts of costs. I was never convinced that the economy had 'turned' as a result of Volker beating inflation.

    The Greenspan approach subsequently went too far, with everyone becoming addicted to high asset prices and when Bernanke solidified the philosophy with the 2% inflation target, it seemed to focus his attention on the effect (inflation), not the cause (interest rates) of trouble. If it ever 2% inflation targeting worked, it seemed illusory to me and it seemed that we had to change the definition of both CPI and inflation to make it 'work' better.

    If inflation targeting is back-to-front and targeting the effect not the cause of trouble, what would happen under a policy that targeted interest rates themselves at 4.5% in a band of 2-6% (Piketty has real interest rates averaging 4.3% over 5 centuries) ? This would give entrepreneur investors and personal investors (savers) both greater certainty and a fairer deal whilst remaining within the economic remit of central banks.

  17. actually it is very simple - velocity of money has never been lower


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