Peering through the wrong end of the telescope?
By Scott Sumner
The past decade has produced some unusual macroeconomic outcomes, and even more unusual new macro theories. One of the very strangest is NeoFisherism. Irving Fisher noted a positive relationship between inflation and nominal interest rates. He suggested that higher rates of expected inflation led to higher nominal interest rates, as lenders insisted on being compensated for the loss of purchasing power resulting from inflation.
A new article published by the Swedish Riksbank (their central bank) turns the Fisher effect on its head. Here’s the title and the abstract:
Interest and inflation rates through the lens of the theory of Irving Fisher
The analysis is based on Irving Fisher’s theory, which posits that the nominal interest rate should be equal to the sum of the expected inflation rate and the real interest rate. The authors also assume that monetary policy is neutral in the long run – i.e. it does not influence the long run development of real economic variables. Using an economic model and empirical estimates with data from several countries, the idea that a low policy rate over a long period of time can lead to low inflation is supported.
I’m a bit puzzled as to why this idea is called “NeoFisherism”. Irving Fisher argued that high inflation leads to high interest rates. In contrast, the NeoFisherians suggest that higher interest rates lead to higher inflation. Are they looking through the “lens” in the wrong direction?
In my view NeoFisherism is a classic example of reasoning from a price change. The question is not whether higher interest rates lead to higher inflation; it’s whether the thing that causes higher interest rates causes higher inflation. Consider three policies that the Bank of Japan or the Swiss National Bank could adopt to cause higher interest rates:
1. Open market sale of bonds, which reduces the supply of base money.
2. Higher interest on bank reserves, which raises the demand for base money.
3. A crawling peg exchange rate regime, where the central bank promises to depreciate the domestic currency at 2% per year against the dollar.
Less supply of base money and/or more demand for base money is deflationary. Thus policies #1 and #2 represent ways of (temporarily) increasing interest rates that end up reducing inflation.
The interest parity condition tells us that a country with a currency that is expected to depreciate will have higher interest rates, and purchasing power parity tells us that a depreciating currency will lead to higher inflation. Thus Policy #3 is a way of (immediately) increasing interest rates, which is also inflationary.
I wish we could get past talking about interest rates, and start focusing on the underlying monetary policies that are being contemplated. I believe this would avoid a lot of confusion about the relationship between nominal interest rates and inflation.
Despite the critical tone of this post, I do have a bit of sympathy for NeoFisherism. They correctly intuit that something is wrong with mainstream theory. For 7 years we’ve been told that monetary policy is “extraordinarily accommodative”. And yet inflation remains low, and indeed has recently fallen even lower. Something is clearly wrong. But here’s what is not wrong—we don’t need to give up the notion that highly expansionary monetary policy leads to high inflation. It does. Rather we need to abandon the notion that the past 7 years have seen expansionary monetary policy. Just as we previously had to abandon the notion that high interest rates in the 1970s were a contractionary policy. And just as before that we had to abandon the notion that low interest rates in the 1930s were an expansionary monetary policy. The NeoFisherians have correctly diagnosed a problem with the mainstream model, but may not have the right solution.
HT: Julius Probst