David Beckworth has an excellent podcast interview with Eric Sims, which touches on both the NeoFisherian heresy and quantitative easing (QE) pessimism. NeoFisherism is the view that lower interest rates are actually contractionary, as the Fisher Effect predicts that low nominal interest rates will be associated with lower inflation rates. QE pessimism is the view that QE is likely to be relatively ineffective at boosting aggregate demand, or at least less effective than we would hope.
I’ve criticized both views, while also acknowledging that they have a point, at least under certain conditions. Rather than saying these two views are wrong, I prefer to say they are incomplete, or poorly specified. Here I’d like to show that these two views are actually two sides of the same coin, something that many pundits seem to miss.
Consider these two claims:
1. Other things equal, an exogenous decision by a central bank to lower its interest rate target or engage in QE is generally expansionary.
2. Generally speaking, the lower the interest rate and the greater the amount of QE, the more contractionary the monetary policy.
While these two statements aren’t exactly contradictory, they do seem a bit hard to reconcile. This confusion leads to both NeoFisherism and QE pessimism, for exactly the same reason.
When a central bank conducts a contractionary monetary policy it tends to reduce NGDP growth rates. Lower NGDP growth leads to lower nominal interest rates. Lower nominal interest rates lead to a greater demand for base money as a share of GDP. If the central bank wants to avoid a 1930s-style depression (and they generally do wish to avoid that outcome), they will engage in QE to accommodate the increased demand for liquidity at low interest rates.
This means that you will often see countries that simultaneously have sluggish growth in NGDP, low interest rates, and QE. Is it any wonder that low interest rates and QE seem relatively ineffective?
I get a lot of pushback from my fellow economists when I criticize the conventional wisdom on interest rates and monetary policy. They say I’m caricaturing the conventional wisdom, and that economists don’t actually believe that low interest rates are easy money. Maybe, but Eric Sims seems to agree that this is the conventional wisdom:
So it becomes sort of a topic of conversation from folks like Williamson or Cochrane in the last several years because the puzzle of our time in some sense is why is inflation so low? Right? We have a coexistence of very low interest rates and low inflation. According to this conventional wisdom, low interest rates are stimulative.
I don’t think low short-term rates are either stimulative or contractionary. I don’t think QE is either stimulative or contractionary. Both are policy tools, which can be employed in an effective or an ineffective manner. It’s easy to point to the latter case; both Japan and Europe provide excellent recent examples of low rates and QE failing to hit the policy target.
What would an effective interest rate/QE policy look like? Suppose the Fed adjusts the monetary base until market expectations of future inflation or NGDP are right on target. Whatever interest rate is associated with that policy is “effective”. And whatever amount of QE is associated with that policy is also “effective”. So QE is 100% effective if done right, and largely ineffective if done in the way that Europe and Japan are currently conducting monetary policy.
Let’s put aside the question of whether the BOJ and ECB currently have the legal authority to conduct effective policy, and just think about this from a technical perspective. What needs to be done?
1. Set a level target for prices or NGDP, and promise to return to the trend line after policy misses.
2. Let open market purchases be guided by forecasts (preferably market forecasts, or at least internal central bank forecasts.) Do “whatever it takes” to equate the price level/NGDP forecast and the policy target.
Under this regime, both the interest rate and the QE will be highly effective. In the absence of this regime, questions of whether low interest rates and/or QE are expansionary are completely incoherent. There is no unambiguous answer, as the question isn’t even clearly specified. Compared to what? Part of what long term strategy?
READER COMMENTS
Christophe Biocca
Jan 15 2020 at 3:06pm
“Whatever it takes” presumes at least an understanding of the direction of the effect, right? If
is false, then “whatever it takes” is actually the opposite of the usual recommendation.
BC
Jan 16 2020 at 5:16am
Suppose a car driver consistently lets his car drift to the very right edge of the road instead of keeping the car near the center. Most of his hard steering will be towards the left, whenever he is in danger of falling off the road. From that, one might be tempted to conclude that steering hard towards the left is ineffective, or even that steering to the left actually pushes the car right, because hard-left steering tends to be associated with cars on the right side of the road. That would not be a correct conclusion, however. Steering to the left can often be an indicator that past driving policy was too right biased.
Daniel
Jan 16 2020 at 11:06am
1. Other things equal, an exogenous decision by a central bank to lower its interest rate target or engage in QE is generally expansionary.
This is a causal statement. Increasing the money supply brings down the short-term nominal rate relative to the natural rate, and increases nominal output (provided the natural rate isn’t collapsing at the same time, which is in the ceteris paribus assumption!). Notice it’s not the rates doing the work (never reason from a price change), but the greater money supply reducing the “price” of money (rate) and increasing the price level of output (the P part of PY). Not surprisingly, the central bank tends to increase the money supply *when* the natural rate is falling, so what looks like a low rate compared to what you’re used to might not be “operatively” low. I believe the conventional theory is right on this, but the conventional interpretation that gets talked about in the business press conflates “low versus natural” with “low compared to what I’m used to or what we’ve seen recently”.
2. Generally speaking, the lower the interest rate and the greater the amount of QE, the more contractionary the monetary policy.
This is a correlational statement. Low interest rates and QE have been seen when the Fed had pursued a contractionary monetary policy and might not still be out of the rut. But that doesn’t mean they cause the contractions. See BC’s comment.
So there you go- ultimately it’s a question of the causal model. Convention has a sensible causal model, and QE pessimism doesn’t.
Mike Sandifer
Jan 16 2020 at 1:38pm
Even though interest rates are a symptom and not a cause, it just seems easier to discuss this topic in the context of the neutral rate. If the nominal target rate is above the neutral rate, money is tight. It’s nice shorthand.
I also find interest rates helpful in thinking about and discussing exchange rate changes. I focus on real rates here, to think about how changes in monetary policy stance, for example, will affect interest rates. Increases in inflation will lower short-term real rates, at least in the short-term, and lower the value of a currency, ceteris paribus. Inflation increases can also be expected to be permanent, which would lower longer-term real rates, further lowering the value of a currency, ceteris paribus. Likewise for real GDP growth.
bill
Jan 16 2020 at 4:55pm
If the commitment to #1 (level target) is strong enough, then it almost won’t matter which forecasts they use. A market forecast would be best and would result in the smoothest level growth in the beginning (and over time). But even a Fed that was much less competent that started out with a 0% growth that reacted by getting growth to 8%, then 0, then 8, would eventually train the market and economy to know that at any given time, NGDP X years out will be 1.04^X and short term volatility would gradually disappear. The key is the commitment being strong.
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