Blog Post

Understanding the neo-fisherite rebellion

The idea that low interest rates are deflationary – that we’ve had the sign on monetary policy wrong! – started as a fringe theory on the corners of the blogosphere 3 years ago. Michael Woodford has now confirmed that modern theory, indeed, implies the Neo-Fisherian view when people’s expectations are infinitely rational.

By: Date: July 19, 2015 Topic: European Macroeconomics & Governance

What’s at stake: Neo-Fisherism is on the blogs again. The idea that low interest rates are deflationary – that we’ve had the sign on monetary policy wrong! – started as a fringe theory on the corners of the blogosphere 3 years ago. Michael Woodford has now confirmed that modern theory, indeed, implies the Neo-Fisherian view when people’s expectations are infinitely rational. For Woodford, this is however a paradox of perfect foresight analysis, rather than something actually relevant for monetary policy.

Are low interest rates deflationary?

Noah Smith writes that over the last three years, a quiet rebellion seems to have sprung up in macroeconomic circles. For some time, it was limited to a few whispers, a couple of papers, and the odd blog post or dinner speech, but it represents a striking break from conventional thinking and is being now addressed by leading New Keynesian authors. The rebellious idea is that low interest rates cause deflation, and high interest rates cause inflation. Noah Smith writes that the Neo-Fisherite idea doesn’t just discount the effectiveness of monetary policy (like RBC models do, or like the MMT people do) – it stands that whole monetary policy universe on its head. If the Neo-Fisherites are right, then not only is the Fed massively confused about what it’s doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

Tony Yates writes that this discussion is not of purely academic interest, though it sounds nerdy and pointless.  Recall where it started. Core inflation is sliding in the US and the ECB. Does this mean that central banks should double down and keep rates lower for longer, or is low inflation, by contrast, caused by the low rates?  It’s pretty crucial to settle this. The discussion connects with recent efforts by central banks to stimulate the economy by announcing that rates will be held low, and fixed, at their natural floors, for long periods of time, before eventually rising, a policy they have dubbed ‘Forward Guidance’.

Ryan Avent writes that the basic logic of the argument is as follows. The economy has an equilibrium real, or inflation-adjusted, interest rate. The real interest rate is essentially the nominal interest rate minus the inflation rate. So if the central bank pushes nominal interest rates down to a low level, then over the long run the inflation rate must inevitably move toward a level consistent with the long-run equilibrium real rate. That is, inflation must fall. Otherwise, the economy would be out of equilibrium forever, which is not how economies work.  John Cochrane writes that in response to the interest rate rise, indeed in the short run inflation declines. But if the central bank were to persist, and just leave the target alone, the economy really is stable, and eventually inflation would give up and return to the Fisher relation fold.

Source: John Cochrane

Noah Smith writes that the opening shot of the Neo-Fisherite rebellion was fired by Minneapolis Fed President Narayana Kocherlakota, in a speech in 2010. The second outbreak of the rebellion came when Steve Williamson wrote a paper in which QE is deflationary and the blog debates it sparkled. The third outbreak happened this month when Michael Woodford directly tackled the Neo-Fisherite view at the NBER Summer Institute.

Michael Woodford’s response: A Paradox of Perfect-Foresight Analysis

Mariana Garcia Schmidt and Michael Woodford address two questions in their latest analysis:

1.     Is-it true that “modern theory” — deriving aggregate demand and supply relations from intertemporal optimization — implies the neo-Fisherian view?

2.     Can one maintain the orthodox view — that maintaining a lower nominal rate for longer should cause higher inflation and capacity utilization — while having a view of expectations that implies that central-bank commitments regarding future policy should have any effect?

Mariana Garcia Schmidt and Michael Woodford write that “modern theory” — deriving aggregate demand and supply relations from intertemporal optimization — implies the neo-Fisherian view when perfect foresight is assumed. The long-run inflation rate is lower the lower level interest rates are pegged to. Thus one can argue that permanently maintained low nominal interest rates must (at least eventually) bring about correspondingly lower inflation rate.

Mariana Garcia Schmidt and Michael Woodford write that people are at least somewhat forward-looking; this is why commitments regarding future policy matter. The assumption of perfect foresight is nonetheless very strong — especially in the context of a novel policy regime, and the anticipated effects of policies announced for many quarters in future Perfect Foresight Equilibrium (PFE) predictions are relevant only to the extent that the PFE is the limit of an iterative process of belief revision and this process converges fast enough for the limit to well approximate the outcome from a finite degree of reflection. But if the process doesn’t converge, the PFE prediction may be quite different from what this model of expectation formation would imply, even if the process of reflection is carried quite far. When considering the case where interest rate is expected to be fixed indefinitely, the authors show that belief revision dynamics don’t converge.

John Cochrane writes that what he can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away. His first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Has the Phillips curve disappeared?

The Phillips curve prescribes a negative trade-off between inflation and unemployment. Economists have been recently debating on whether the curve has disappeared in the US and Europe. We report some of the most recent views.

By: Silvia Merler Topic: Global Economics & Governance Date: November 21, 2017
Read article More on this topic More by this author

Blog Post

Powell's Federal Reserve

With the appointment of Jerome Powell as the next Fed’s chairman, President Trump break a tradition of bipartisan re-nomination and chooses someone who is not an economy by formation. We review economist’s opinions on this choice and the challenges ahead.

By: Silvia Merler Topic: Global Economics & Governance Date: November 13, 2017
Read article More on this topic More by this author

Blog Post

The Bank of England’s dovish hike

For the first time since 2007, the Bank of England raised interest rates, with a hike of 25 basis points. At the same time, it provided forward guidance that outlines a very gradual path for future increases. We review the economic blogosphere’s reaction to this decision.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 6, 2017
Read article More on this topic More by this author

Blog Post

The capital tax cut debate

How much do workers gain from a capital gains tax cut? CEA chairman Hasset claims the tax cut will cause average household labour income to increase by between $4000 and $9000. Several commentators note this implies that more than 100% of the incidence of the tax is on labour. This question has triggered a heated discussion in the economic blogosphere, which we review here.

By: Silvia Merler Topic: Global Economics & Governance Date: October 30, 2017
Read article More by this author

Blog Post

Bailout, bail-in and incentives

Ever since the outbreak of the global financial crisis, more and more rules have been developed to reduce the public cost of banking crises and increase the private sector’s share of the cost. We review some of the recent academic literature on bailout, bail-in and incentives.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 23, 2017
Read article More on this topic More by this author

Blog Post

An irrational choice: behavioural economist wins Nobel Prize

Richard Thaler was awarded this year's Nobel Prize in Economics for his contributions to the field of behavioural economics. His work documents a set of cognitive biases affecting economic decision-making and casts doubt on commonly-held assumptions about the rational ‘homo economicus’ that inhabits economic models and theories. What are the implications for the economics discipline and public policy?

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: October 16, 2017
Read article More on this topic More by this author

Blog Post

On the cost of gun ownership

On 1 October 2017, 59 people were killed and another 489 injured in what is currently the deadliest mass shooting in US modern history. The author reviews recent contributions on the economic cost of gun violence, as well as the impact of regulation.

By: Silvia Merler Topic: Global Economics & Governance Date: October 11, 2017
Read article More on this topic More by this author

Blog Post

The Economics of Healthcare

Healthcare reform has been a thorn in the side of the US administration for several months, prompting President Trump to declare that “Nobody knew that healthcare could be so complicated.” We review recent economists’ views on the issue.

By: Silvia Merler Topic: Global Economics & Governance Date: October 2, 2017
Read article More on this topic More by this author

Blog Post

The Fed’s Unwinding

The Federal Open Market Committee (FOMC) held short-term interest rates steady on September 20th and announced that starting from October 2017 the Fed will gradually shrink its balance sheet, which grew considerably in response to the Great Recession. We review economists’ views on this move.

By: Silvia Merler Topic: Global Economics & Governance Date: September 25, 2017
Read article More on this topic More by this author

Blog Post

Global Imbalances

The recent IMF’s External Sector Report highlighted the persistence of imbalances and a switch of imbalances towards advanced economies. We review recent contributions on this topic.

By: Silvia Merler Topic: Global Economics & Governance Date: September 21, 2017
Read article More on this topic More by this author

Blog Post

Hurricane Harvey’s economic impact

What’s at stake: tropical storm Harvey has caused unprecedented and catastrophic flooding in southeastern Texas. We review recent estimates of the economic impact of this natural disaster.

By: Silvia Merler Topic: Global Economics & Governance Date: September 4, 2017
Read article More on this topic More by this author

Blog Post

The US Antitrust Counter-Revolution

Plenty of recent research has highlighted a rise in concentration in the US economy, across different sectors. Economists are now wondering to what extent this is attributable to a shift in the antitrust enforcement philosophy. We review contributions to this debate.

By: Silvia Merler Topic: Global Economics & Governance Date: July 31, 2017
Load more posts