Abstract:
The long period of quiet inflation at near-zero interest rates, with large quantitative easing, suggests that core monetary doctrines are wrong. It suggests that inflation can be stable and determinate under a nominal interest rate peg, and that arbitrary amounts of interest-paying reserves are not inflationary. Of the known alternatives, only the new-Keynesian model merged with the fiscal theory of the price level is consistent with this simple interpretation of the facts.
I explore two implications of this conclusion. First, what happens if central banks raise interest rates? Inflation stability suggests that higher nominal interest rates will result in higher long-run inflation. But can higher interest rates temporarily reduce inflation? Yes, but only by a novel mechanism that depends crucially on fiscal policy. Second, what are the implications for the stance of monetary policy and the urgency to “normalize?” Inflation stability implies that low-interest rate monetary policy is, perhaps unintentionally, benign, producing a stable Friedman-optimal quantity of money, that a large interest-paying balance sheet can be maintained indefinitely. However, with long run stability it might not be wise for central bankers to exploit a temporary negative inflation effect.
The fiscal anchoring required by this interpretation of the data responds to discount rates, however, and may not be as strong as it appears.Big novelties in this draft -- at least things I have learned recently:
1) There is now a mechanism that produces a temporary decline in inflation from a rise in interest rates. It comes out of the fiscal theory of the price level and long term debt. If the Fed unexpectedly raises interest rates, that lowers nominal bond prices. If the real present value of surpluses does not change (if monetary policy does not change fiscal policy), then a lower nominal value of the debt and unchanged real value of the debt require a drop in the price level. It works, but it has nothing to do with your grandfather's ISLM, "aggregate demand,'' Phillips curve, money, sticky prices, and so on.
2) In this case and more generally, a temporary decline in inflation when interest rates rise unexpectedly does not rescue traditional policy advice!
It's only temporary! So you do not get long-lasting disinflation or stabilization out of raising rates. Raising rates gives you a temporary disinflation, then inflation gets worse. This is a mechanism perhaps for the 1970s, when each rate rise fell apart in more stagflation -- Chris Sims calls it "stepping on a rake" -- not the 1980s. For that sort of disinflation you need fiscal policy too.
And since only unexpected rate changes have the negative inflation effect, it can't be the basis of systematic, expected policy, like the Taylor rule in old-Keynesian models.
3) If unexpectedly raising interest rates lowers inflation temporarily, and then they go up, and vice versa, that doesn't mean it's a good idea for the Fed to exploit this mechanism for fine-tuning the path of inflation. the Fed is likely better off just raising interest rates and waiting.
In sum, there is a big difference between a temporary negative sign and a long run positive sign, long run stability, and the traditional view which is a temporary and permanent negatives sign and long-run instability.
4) All of this stability needs fiscal backing or "anchoring." Why do people want government debt so much with awful prospective deficits? The only reasonable answer is that we live in a time of very low interest rates. The present value of surpluses is high because the discount rates are low, not because prospective surpluses are large, but because discount rates are low. Discount rates could change quickly.
There will be a few more drafts of this paper and slides and talks. Unless one of you finds a big mistake and clears up my thinking on it.
I'm interested in what you've done with the long term debt here. I'd like to believe that your thinking there was influenced in some part by my comment on your blog post last year and my own post on the topic. Is that right?
ReplyDeleteThanks Prof, will analyse in detail, just short point - one need get rid of this idea of a long-run steady state and you go to the idea of regimes instead. And that comes from the econometric's literature, and these regimes are very persistent. Once you’re in one of these regimes, what you want to do is make the best monetary policy that you can based on that regime.
ReplyDeleteIt seems to me your model is creating a friction on nominal interest rates with long-term debt. So an oversimplification is: A rise of r by 2% (from govt doing something or from a recession) may lead to a rise in i of say only 1% if i is rigid. Fisher equation says that's a drop in inflation.
ReplyDeleteI wonder how Japan runs huge fiscal deficits, and keeps interest rates at zero, and has no inflation (despite virtually no unemployment).
ReplyDeleteIs it because they owe the money to themselves? Indeed, the world owes Japan money?
They have good property zoning (and thus avoid US property spikes)?
How does running trade surpluses play into interest rates?
When the Bank of Japan prints money and buy bonds, is that a signal the fiscal deficits are evaporating? Does this actually strengthen the public's trust in the currency?
Some have posited when a national currency is backed by assets, the public trusts the currency. The Bank of Japan is buying ETFs.
I wonder if US macroeconomists can address the Japan situation.
I really like this paper. But I disagree. My short post in response:
ReplyDeletehttp://worthwhile.typepad.com/worthwhile_canadian_initi/2016/12/john-cochrane-on-neo-fisherianism-again.html
I started reading but, being uninitiated in economics jargon and theories, did not get far (not yet, at least). At Michelson & Morley I realised that they had a big advantage over you --- they were observing a non time-variant, non chaotic, deterministic, system. Maybe not linear though. I think you might be better off taking analogies from chaos theory. They do find predictable characteristics in chaotic systems, despite the apparent difficulty.
ReplyDelete--E5
John,
ReplyDelete"1. If the Fed unexpectedly raises interest rates, that lowers nominal bond prices."
Yes, but lower bond prices do not reduce the liability owed by the U. S. government (taxpayers) on those bonds. When the U. S. government retires debt, they do it at par (even if a market discount is available).
"If the real present value of surpluses does not change (if monetary policy does not change fiscal policy), then a lower nominal value of the debt and unchanged real value of the debt require a drop in the price level."
Uh, no. Again, the U. S. government retires it debt at par, not at a market discount or premium.
"2. In this case and more generally, a temporary decline in inflation when interest rates rise unexpectedly does not rescue traditional policy advice. It's only temporary. So you do not get long-lasting disinflation or stabilization out of raising rates. Raising rates gives you a temporary disinflation, then inflation gets worse."
Incomplete. Any analysis of the price of credit (interest rate) must also include the quantities (supply / demand) involved. Raising interest rates gives you a permanent disinflation when it reduces the demand for credit (assuming an elastic supply).
Also, what the late seventies and early eighties should have demonstrated (to those interested) is that the central bank was able to change prices more quickly than private individuals. Hence the central bank was able to maintain a positive real interest rate over a significant time frame.
The increase in price of goods and services overtime is the result of inflation. But Japan has no deficit and no inflation rates. The central banks have a goal of keeping the inflation rate per year around roughly 2%-3%. How long can Japan go without having an inflation rate and will there be an aftershock because of it.
ReplyDeleteI need more time to digest this important paper.
ReplyDeleteI have a comment regarding your walking stick analogy on page 9.
ReplyDeleteI think the description could be improved. A better description might be useful, because the analogy is quite good.
“Upside down” does not describe what is happening in that analogy. You have a walking stick with a top and a bottom. You can hold it normally from the top (from waist level, say) or you can balance it abnormally from the bottom (again, from waist level, say). The stick is never upside down. The top is never upside down. The bottom is never upside down. (Your own description confirms all that, apart from the “upside down” phrase as you use it.) And of course the person is never upside down. Everything is right side up. Nothing is upside down.
Something like that. I don’t have the exact words.
My comment may seem trite, and I don’t mean to sound Monty Python, dead parrot-ish in my own analysis, but I personally found the description unnecessarily disruptive, particularly given that the analogy is really quite good (as is the one with the seal).
Interesting paper too. I'm still absorbing it.
Much simpler explanation. The transmission mechanisms of monetary policy are still not functioning well. QE does not get transmitted to the real markets. No inflation. Or growth. Or much of anything. We don't need a grand theory for that, although the paper is a great read. Then again, I have been using your writing tips for PhDs forever.
ReplyDeleteI have not yet read all, but here are several (very) minor typos I have found so far:
ReplyDelete1) (page 3) “Raw correlations are of little use,” => ”Low correlations are of little use,”
2) (page 115) “Managing the U.S. Government?s Debt,” => ”Managing the U.S. Government’s Debt,”
3) (page 115, “Replication and Diagnosis.”) “manuscript” => “Manuscript”
4) (page 138) “Difference (71),” => “Difference (72),”
5) (page 139) “It straightforward to check.” => “It is straightforward to check.”
I will try to read all when I have enough time to read through more than 100 pages. There is a lot to learn from your provocative paper.
Aside: I also liked your interview and presentation at 32 NBER Macro Conference (especially an “umbrella” illustration). I hope for your blogging on this paper or more on the quiet ZLB episode, if you found something new to reflect, at the conference.