Do Low Interest Rates Actually Cause Deflation?

by: Fabian Knigge

Since a couple of years, central banks around the world have been struggling with deflationary developments. The answer to this was as usual: lowering interest rates. And once that proved to be insufficient, central banks implemented large-scale asset purchase programs. And still inflation is not picking up. For example, in the US, the inflation rate has fluctuated between 1% and 2% for the last 3 years, and the latest reading from December was just 0.8% (though this was mainly due to the lower oil price). Another almost classic example by now is Japan which is still struggling to lift inflation after 20 years of monetary stimulus.

Source: Fed

So how is it possible that after years of monetary stimulus inflation is still subdued? Here is a crazy idea: maybe it is because interest rates are low! This theory is called Neo-Fisherite after the monetary economist Irving Fisher and has been described by Noah Smith here and here. In the following, I will mainly draw on these two articles.

The intuition of the Neo-Fisherites comes from the Fisher equation which states that the nominal interest rate is equal to the sum of the real interest rate and inflation.

r_nominal = r_real + inflation

Note that this is just an assumption which is true by definition. Now, the basic understanding of economists is that if the central bank lowers the nominal interest rate, inflation will increase and the real interest rate will decrease. But what if r_real is more or less fixed in the long run? That is exactly the intuition of the Neo-Fisherite theory. If the central bank cannot influence r_real in the long run, keeping nominal interest rates low for a long time will ultimately lead to a fall in inflation. The central bank might influence the real interest rate in the short run, but over time it will revert back to its equilibrium level. Then, in order for the equation to hold, inflation has to go down if nominal interest rates are kept at a low level.

The first economist who expressed his doubts about a sustained low interest rate environment was the head of the Federal Reserve bank of Minnesota, Narayana Kocherlakota. In a 2010 speech, he said:

"Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run."

"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."

In 2013, Stephen Williamson, Vice President of the St. Louis Fed, wrote a paper in which he also claimed that QE could be deflationary. He was joined by Stephanie Schmidt-Grohe and Martin Uribe, who in a paper found that raising interest rates can lead to inflation, and later also by Chicago economist John Cochrane. In a paper from November 2014, he concluded not only that higher interest rates raise inflation, but also that in some cases higher interest rates can even stimulate the economy in the short term.

"The basic logic is pretty simple: raising nominal interest rates either raises inflation or raises real interest rates. If it raises real interest rates, it must raise consumption growth. The prediction is only counterintuitive because for so long we have persuaded ourselves of the opposite."

I find this theory very interesting. It is completely contrary to how we believe the interest rate mechanism works; however, it is certainly intuitive. In two of my previous posts (here and here), I expressed my doubts about a QE program in the Eurozone. I still have not come across any study that has proven that QE works. So, I find this theory very much appealing and convincing. If the Neo-Fisherite theory is true, this would mean that the current monetary policy not just in Europe is only manifesting the deflationary environment. And I see some evidence in favor of the Neo-Fisherites. Japan is the most obvious one, and also in the US, heavy monetary stimulus has failed to lift inflation back towards 2%.

Despite all this, I honestly hope the Neo-Fisherites are wrong.

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