## Thursday, March 31, 2016

### Neo-Fisherian caveats

Raise interest rates to raise inflation? Lower interest rates to lower inflation? It's not that simple.

A correspondent from an emerging market wrote enthusiastically. His country has somewhat too high inflation, currency depreciation and slightly negative real rates. A discussion is going on about raising rates to combat inflation. Do I think that lowering rates in this circumstance is instead the way to go about it?

As you can tell, posing the question this way makes me very uncomfortable! So, thinking out loud, why might one pause at jumping this far, this fast?

Fiscal policy.  Fiscal policy deeply underlies monetary policy. In my own "Fisherian" explorations, the fiscal theory of price level is a deep foundation. If the government is printing up money to pay its bills, the central bank can do what it wants with interest rates, inflation is coming anyway.

Conversely, underlying the decline in inflation in the US, Europe, and Japan is an extraordinary demand for nominal government debt.

Bond markets seem to think we'll pay it off. And that is not too terribly an irrational expectation. Sovereign debts are self-inflicted wounds. A little structural reform to get growing again, tweaks to social security and medicare, and next thing you know we're back in the 1990s and wondering what to do when all the government bonds are paid off. Also, valuation is more about discount rates than cashflows. People seem happy -- for now -- to hold government debt despite unusually low prospective returns.

My correspondent answers that his country is actually doing well fiscally.  However, his country is also a bit low on reserves and having exchange rate and capital flight problems.

But current deficits are not that important to inflation either in theory or in fact. The fiscal policy that matters is expectations of very long term stability, not just a few years of surpluses. Also, contingent liabilities matter a lot. If investors in government debt see a government that will bail out all and sundry in the next downturn, or faces political risks, even temporary surpluses are not an assurance to investors.  (Craig Burnside, Marty Eichenbaum and Sergio Rebelo's "Prospective Deficits and the Asian Currency Crises, in the JPE and ungated here is a brilliant paper on this point.)

Rational expectations. The Fisherian proposition also relies deeply on rational expectations. In the simplest version, $$i_t = r + E_t \pi_{t+1}$$, people see nominal interest rates rise, they expect inflation to be higher, so they raise their prices. As a result of that expectation inflation is, on average, higher. (Loose story alert.)

How do they expect such a thing? Well,  rational expectations is sensible when there is a long history in one regime. People see higher interest rates, they remember times of high interest rates in the past, like the late 1970s, so they ratchet up their inflation expectations. Or, people see higher interest rates, and they've gotten used to the Fed raising interest rates when the Fed sees inflation coming, so they raise their expectations. The motto of rational expectations is "you can't fool all of the people all of the time," not "you can never fool anyone," nor "people are clairvoyant."

The Fisherian prediction relies on the interest rate change to be credible, long-lasting, and to lead to the right expectations. A one-off experiment, that might be read as cover for a dovish desire to boost growth at the expense of more inflation, and that might be quickly reversed doesn't really map to the equations. Europe and Japan, stuck at the zero bound, with a fiscal bonanza (low interest costs on the debt) and slowly decreasing inflation expectations is much more consistent with those equations.

Liquidity. When interest rates are positive and money does not pay interest, lowering rates means more money in the system, and potentially more lending too. This classic liquidity channel, which goes the other way, is absent for the US, UK, Japan and Europe, since we're at the zero bound and since reserves pay interest.  (Granted, I couldn't get the equations of the liquidity effect to be large enough to offset the Fisher effect, but that depends on the particulars of a model. )

Successful disinflations. Disinflations are a combination of fiscal policy, monetary policy, expectations, and liquidity. Tom Sargent's classic ends of four hyperinflations tells the story beautifully.

Large inflations result from intractable fiscal problems, not central bank stupidity. In Tom's examples, the government solves the fiscal problem; not just immediately, but credibly solves it for the forseeable future. For example, the German government in the 1920s faced enormous reparations payments. Renegotiating these payments fixed the underlying fiscal problem. When the long-term fiscal problem was fixed, inflation stopped immediately. Since everybody knew what the fiscal problem was, expectations were quickly rational.

The end of inflation coincided with a large money expansion and a steep reduction in nominal interest rates. During a time of high inflation, people use as little money as possible. With inflation over, real money demand expands.  There was no period of monetary stringency or interest-rate raising preceding these disinflations.

So these are great examples in which the Fisher story works well -- lower interest rates correspond to lower inflation, immediately. But you can see that lower interest rates are not the whole story. The central bank of Germany 1922 could not have stopped inflation on its own by lowering rates.  I suspect the same is true of high inflation countries today -- usually something is wrong other than just the history of interest rates.

So, apply new theories with caution!

To the raising interest rates question for the US and Europe, some of the same considerations apply. We won't have any liquidity effects, as central banks are planning to just pay more interest on abundant reserves. Higher real interest rates will raise fiscal interest costs, which is an inflationary shock by fiscal theory considerations. The big question is expectations. Will people read higher interest rates as a warning of inflation about to break out, or as a sign that inflation will be even lower?

1. The last two posts are fascinating.

Yet--President Ronald Reagan ran large deficits, both primary (operating) and total. Perhaps it was then that the mantra "deficits don't matter" seized the GOP.

Volcker then jacked up rates to high teens, and inflation sank thereafter to the mid-single digits, from low double digits. Inflation was there when Bush The Elder took over. Back in those days, 5% inflation was accepted as "good enough."

Certainly, in the 1980s public could not have anticipated the Clinton years federal budget surplus. The intelligentsia investing public did not, and there was much hand-wringing about the ever-growing national debt. Treasury rates followed inflation down thereafter, as the investing public never quite believed inflation would keep sinking. Great time to own T-bonds, btw.

Somehow the Volcker years just don't fit the neo-Fisherian model.

A couple other quibbles: You use a Phillips Curve assumption, but in the past 20 years it is more of a Phillips Phlat-line. No matter the unemployment rate, inflation does not seem to rise. In Japan even more so, dead inflation with essentially no unemployment. Same in Thailand, where there are chronic labor shortages, but no inflation.

Is the Phillips Curve dead for some sort of structural reasons? Does your model make sense if the Phillips Curve is dead?

Still, lots of fun to read.

How did Japan sink into deflation for 20 years despite chronic federal deficits?

1. They self finance their deficits. As such, bond holders in Japan hold significant political power.

3. This comment has been removed by a blog administrator.

4. Is you correspondent from Russia? Because on each "correspondent tells me..." point I have 100% recognition of what we're dealing with here.

5. I really can get the fisher relation idea.
Given that the real interest rate is determined by the real side of the economy, by arbitrage, nominal interest rate and inflation should move together (admitting a stable real interest rate). By yours posts and the literature, I think most economists agree that this relation will prevail in the long run.

But what about the short run?
Doesn't almost all the Central Banks in the world raise interest rates to fight against inflation?
When did this story begin?
What was the initial rationale to carry out this procedure?

I think it relied on some kind of rigid expectation. In this way, increasing nominal interest rate means increasing real interest rate and, then, this would weaken the demand today lowering prices today. Thus, at least in the short run, increase nominal interest rate leads to lower inflation.

But, does it fit in some rational expectation model? If I'm not wrong, it's exactly what are you looking for.

What are the evidences in favor and against this effect in the short run? Are they robust?

That said, I also would like to know why among economists this simple logic of the effect of nominal interest rate on inflation - maybe coming from traditional IS/LM (rigid expectations!) - is so entrenched. In the place I study, this effect is taken for granted. Questioning it is almost a heresy despite the fact that rational expectation hypothesis is almost unquestionable there. So, what is the logic behind this effect!?

I really don´t understand why this question - the short run effect of nominal interest rate on inflation - is not largely discussed among academics.

6. I really can get the fisher relation idea.
Given that the real interest rate is determined by the real side of the economy, by arbitrage, nominal interest rate and inflation should move together (admitting a stable real interest rate). By yours posts and the literature, I think most economists agree that this relation will prevail in the long run.

But what about the short run?
Doesn't almost all the Central Banks in the world raise interest rates to fight against inflation?
When did this story begin?
What was the initial rationale to carry out this procedure?

I think it relied on some kind of rigid expectation. In this way, increasing nominal interest rate means increasing real interest rate and, then, this would weaken the demand today lowering prices today. Thus, at least in the short run, increase nominal interest rate leads to lower inflation.

But, does it fit in some rational expectation model? If I'm not wrong, it's exactly what are you looking for.

What are the evidences in favor and against this effect in the short run? Are they robust?

That said, I also would like to know why among economists this simple logic of the effect of nominal interest rate on inflation - maybe coming from traditional IS/LM (rigid expectations!) - is so entrenched. In the place I study, this effect is taken for granted. Questioning it is almost a heresy despite the fact that rational expectation hypothesis is almost unquestionable there. So, what is the logic behind this effect!?

I really don´t understand why this question - the short run effect of nominal interest rate on inflation - is not largely discussed among academics.

1. Caio,

"Raising interest rates to fight inflation" and "maintaining a positive real interest rate" are not the same thing.

In the first case the central bank is targeting a lower inflation rate - hence the term "fighting" inflation.

In the second case the central bank is targeting a real interest rate and not "fighting" inflation per se.

7. When you talk about the fiscal policy affecting the inflation rate, you are reasoning by the fiscal theory of the price level (FTPL), right?

But, the FTPL determines just the level of the price, not the inflation rate (this is still being determined by nominal interest rate - fisher relation). Unless the expectation about the future government surpluses is constantly changing, the fiscal policy will not affect the inflation rate.

1. Calo,

https://en.wikipedia.org/wiki/Fiscal_theory_of_the_price_level

"The fiscal theory of the price level is the idea that government fiscal policy affects the price level: for the price level to be stable (to control inflation), government finances must be sustainable: they must run a balanced budget over the course of the business cycle, meaning they must not run a structural deficit."

"The fiscal theory states that if a government has an unsustainable fiscal policy, such that it will not be able to pay off its obligation in future out of tax revenue (it runs a persistent structural deficit), then it will pay them off via inflating the debt away."

The fiscal theory of the price level DOES NOT stipulate that fiscal policy choices set the absolute price level. It says that fiscal policy choices determine the trajectory for the price level.

The fiscal theory does miss one important codicil - even if a government does not run a balanced budget, it can still maintain an independent monetary policy by financing budget deficits with the sale of equity claims on future tax revenue.

8. I believe the Fed make a classic mistake in the late 90's early 2000's when they mistook good disinflation/deflation as the worrisome kind. They become much too accommodative when essentially it was high productivity growth and globalization that was tempering prices. This was good for business and good for the consumer. In 2003 with the economy already recovering the Fed put the pedal to the floor and keep it there too long, fueling the housing and stock market bubbles. We now have a deflationary impulse that is cause by over indebtedness and it is proving intractable.This problem needs fiscal and tax attention. More debt ultimately makes this worse.

9. Professor Cochrane,

You said: "Fiscal policy. Fiscal policy deeply underlies monetary policy. In my own "Fisherian" explorations, the fiscal theory of price level is a deep foundation. If the government is printing up money to pay its bills, the central bank can do what it wants with interest rates, inflation is coming anyway."

In this section - you're equating interest rate targets with monetary policy. Is that intentional? Just as you indicate that fiscal policy can disrupt the notion that inflation follows nominal rates (i.e., "inflation is coming anyway"), I can imagine monetary policy scenarios where the same is true. Do you disagree?

10. This is a fascinating problem that aries when an economy enters mild deflation---people migrate to cash for savings, and from there move to extensive cash transactions to avoid the tax man.

See Japan (below)---they are actually printing more large bills to handle the demand. They have about $7000 (yen equivalent) in circulation per resident. Egads, a typical family of four has$28k under the mattress?

Of course, the above-ground economy then has to shoulder a larger fraction of the tax burden--driving more of it underground.

-----

Japan to print additional ¥10,000 bills as more people stash their cash at home
JIJI

APR 7, 2016 ARTICLE HISTORY
PRINT
SHARE

The Finance Ministry plans to increase the number of ¥10,000 bills in circulation, amid signs that more people are hoarding cash.
It will print 1.23 billion such notes in fiscal 2016, 180 million more than a year earlier. The number of ¥10,000 bills issued annually leveled off at around 1.05 billion in the fiscal years from 2011 to 2015.
Some financial market sources believe it is because more people are keeping their money at home rather than in banks, because interest rates on deposits have fallen to almost zero after the Bank of Japan introduced a negative interest rate in February.
The total amount of cash stashed at home is estimated to have surged by nearly ¥5 trillion to some ¥40 trillion in the past year, Hideo Kumano, chief economist at Dai-ichi Life Research Institute, said.
He attributed the sharp increase to people not wanting their wealth to become known to authorities following the introduction of the My Number common identification system for tax and social security.
In addition, the BOJ’s negative rate policy “may have fueled concerns among the public about depositing their money in banks,” Kumano said.
There will be 200 million ¥5,000 bills issued in fiscal 2016, down by 80 million, and 1.57 billion ¥1,000 bills, down by 100 million.
Recent BOJ data show daily averages for currency in circulation rose 6.7 percent from a year before to ¥90.3 trillion at the end of February, the sharpest growth in 13 years.
The number of ¥10,000, ¥5,000 and ¥1,000 bills in circulation increased 6.9 percent, 0.2 percent and 1.9 percent, respectively."

--30--

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.