Further Thoughts On NeoFisherism

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by: Scott Sumner

David Beckworth recently interviewed Stephen Williamson, who is an advocate of the NeoFisherian approach to thinking about monetary policy and interest rates. Williamson argues that a policy of permanently reducing interest rates is disinflationary. Others think this idea is crazy. I'm not in either camp, and I keep looking for ways to explain why. Here are some facts about monetary policy, which seem related to this issue:

1. In the short run, nominal interest rates can be reduced with a tight money policy.

2. In the short run, nominal interest rates are usually reduced with an easy money policy.

3. Because money is neutral in the long run, any monetary policy that permanently reduces nominal interest rates must be disinflationary.

4. A tight money policy reduces the natural rate of interest.

All of these claims are pretty easy to justify, and none seem particularly controversial. But they raise an interesting puzzle. Points #1, #3 and #4 all seem sort of NeoFisherian in spirit, consistent with the claims made by Stephen Williamson and John Cochrane. So why are so many mainstream economists horrified by NeoFisherism? I think the sticking point is #2.

The vast majority of the time, a reduction in interest rates on any given day represents an easier monetary policy than a counterfactual policy where the central bank doesn't reduce interest rates. Not always (in which case #1 and #3 would no longer be true), but the vast majority of the time. But the NeoFisherian thought experiment requires that the lower rates be achieved via tighter monetary policy.

I think that people are confused about what NeoFisherians are talking about when they discuss policy option number three. In the minds of most economists, switching to a permanently lower interest rate seems like an expansionary monetary policy, because on any given day cutting interest rates usually is an expansionary monetary policy. Here's why they are wrong:

1. If you don't want the price level to blow up, then any permanent switch to a lower interest rate must be done with a tighter monetary policy. If the central bank tried to do it with an easier money policy, then it'd have to inject larger and larger amounts of liquidity, eventually causing hyperinflation and then complete collapse of the system. So any sustainable policy of low interest rates must be contractionary.

2. A contractionary monetary policy lowers the natural rate of interest. I think many economists picture a world where the natural rate of interest is not affected by monetary policy. In that world, lowering the policy rate makes policy more expansionary, because the stance of monetary policy is the gap between the policy rate and the natural rate (assumed to be stable). In fact, any sustainable policy of low rates must be caused by tight money, and any tight money policy will reduce the natural rate of interest so much that monetary policy does not get easier, despite the lower Fed funds target. This is Japan since 1995.

So far I've presented a picture that is somewhat sympathetic to the NeoFisherians. Let me conclude with a discussion of what I don't like about the way NeoFisherians present their theory.

1. The listener is led to believe that if you want lower inflation, you need to cut interest rates. I'd say if you want lower inflation, you need to cut interest rates via a tight money policy. Any attempt to achieve lower inflation via a cut in interest rates achieved through an easier money policy will end in disaster.

2. Because the vast majority of rate cuts represent easier money than the counterfactual of not cutting rates on that given day, it is not accurate to imply that the first step to lowering inflation is for the central bank to do the sort of rate cut that it often does do - i.e., liquidity injections. Instead, the NeoFisherians should argue that the first step to lower inflation is for central banks to do the sort of rate cut that the Swiss National Bank did in January 2015, when it simultaneously appreciated its currency and created a credible policy of further currency appreciation going forward. That credible promise led to lower nominal interest rates via the interest parity condition, and lower inflation expectations via the currency appreciation (combined with PPP).

PS. Has anyone commented on the similarity between the NeoFisherian puzzle identified in points #1-#4 above, and the puzzle that led to the Dornbusch overshooting model? The overshooting model was an attempt to resolve the following puzzle in a conventional Keynesian fashion:

Puzzle: Easy money seems to lead to both actual currency depreciation and expected currency appreciation.

Rudi Dornbusch wanted to show how easier money could lead to expected currency appreciation (which is an implication of lower nominal interest rates combined with the interest parity condition). His solution was overshooting.

The NeoFisherian model assumes a permanent change in the interest rate, which rules out Dornbusch's resolution to this puzzle. If you make the rate cut permanent, then his solution no longer works; you take overshooting off the table. In that case, the NeoFisherian result is the only explanation left standing. Now it is a tighter money policy that reduces interest rates, and that tighter money also makes the currency become expected to appreciate forever, lowering inflation.