NeoFisherism and QE pessimism
By Scott Sumner
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?