Steve Williamson, the Fisher Effect & Raising the nominal Fed rate
I just watched the debate between Mark Thoma and Steve Williamson. (youtube video) As I see it, the main issue was the direction of causality in the Fisher equation. In the end, I agree with Mr. Williamson.
The basic Fisher equation is…
Real rate = nominal rate – expected inflation
As the real rate is said to be independent of monetary policy in the longer-run, the nominal rate and the expected inflation move together as time goes by.
So if the real rate wants to be -1% for instance, in the long run you would see either of these two outcomes…
-1% = 0% – 1%
-1% = 2% – 3%
In the second equation, expected inflation is higher. How did that happen? Was it because the nominal rate rose?
During the debate, the question came up whether to raise the nominal Fed rate or not. Mr. Williamson, who is in favor of raising the Fed rate like me, said that expected inflation will follow the nominal rate in the middle and long-run according to the Fisher effect. The basis of this idea is that the real rate is independent of monetary policy in the longer-run... such that the nominal rate will guide the expected inflation rate. The opposite direction of causality happens in the short-run.
Mr. Williamson implies that a higher nominal rate of 2% would guide a 3% expected inflation rate through time. The other implication is that the low nominal central bank rates we see around the world have led to low inflation rates by the same long-run guiding effect in the Fisher equation.
Mr. Williamson made a case that the short-run effects of monetary policy have worn off. And since we are now in the long-run of monetary policy, expected inflation is low because it seeks balance with the low nominal rates. I agree with him. And I also agree with him when he says that inflation will not rise as central bankers say it will.
I have been calling for tighter monetary policy for a different reason, because according to my research of effective demand, the output gap is much smaller than the CBO says. I see we are reaching the end of the business cycle. Some $100 billion more in real GDP and the spare capacity is all gone. This leads me to want tighter monetary policy. Yet, Mr. Williamson takes a different yet complementary approach to raising the Fed rate.
He acknowledges that there would be a short-term adverse reaction to raising the Fed rate, but then as that wore off, expected inflation would rise with the natural business cycle dynamics. Inflation is what economists like Mr. Thoma and Mr. Krugman want. But they want inflation to drive the real rate lower. But if the real rate is independent of monetary policy in the long-run, holding the Fed rate at the zero lower bound will not lower the real rate, but rather lower inflation, according to Mr. Williamson. The real rate edges higher. This is actually what we have been seeing.
There is a natural tendency for the real rate to rise during the expansion phase of the business cycle. So as the economy is now reaching the natural level of GDP, the real rate, which is negative, wants to rise to around 2%, where it would be naturally balanced. Keeping the nominal rates low means inflation will go lower as the real rate rises naturally. Yet,, inflation meets resistance as it goes toward 0%. So the real rate stays negative and can’t rise to its natural level. Outright deflation would allow the real rate to rise to its natural level.
Monetary policy is manufacturing an abnormally low real interest with the hopes of pushing GDP back to a higher level. It is an unnatural process. Mr. Williamson sees a higher Fed rate as a natural process, which would allow both inflation and the real rate to rise to their natural target levels in the long-run.
Mr. Thoma responds to this by giving the opposite direction of causality in the Fisher equation. He implies that expected inflation always drives the nominal rate, in the long-run and short-run. So Mr. Thoma says that inflation has to rise first as an overall general principle in order to raise the nominal rates, whether short or long-run. In such a case you have to generate demand first to generate inflation.
Mr. Thoma says that best way to increase demand is through tax incentives for investment. I do not like this approach because consumption demand by labor has to come first before business investment will pick up.
So, who is right? While Mr. Williamson says the direction of causality between nominal rates and expected inflation can go both ways depending on short or long-run. Mr. Thoma says the direction of causality goes only in one direction.
In the end, it is Mr. Williamson’s distinction between the short-run and longer-run equilibrium effects of the Fisher equation that wins out. Holding the central bank rates low for so long caused the low inflation problem. The way to get the benefits of higher inflation and a natural real rate is to raise the nominal Fed rate, accepting a temporary period of economic contraction in the short-run.
Related post:
Williamson, Stephen. Phillips Curves and Fisher Relations. Stephen Williamson: New Monetarist Economics. December 15, 2013.
I hope Im not being arrogant but I think everyone has it wrong.
Imagine all the excess reserves where just transferred into the hands of the public evenly and at a measured pace and that reserves could be used for transactions just like deposits.
Inflation would pick up because of higher spending and the interest rate on reserves would increase simultaneously as demand for deposits is substituted towards demand for reserves. There’s your real rate at its natural level.
You just need to get around the structural blockages (credit channel, imbalanced monetary transmision mechanism). Its not as simple as adjusting a target interest rate IMO.
“…we are now in the long-run of monetary policy.”
That’s not true. The U.S. economy downshifted very quickly. It has underproduced by up to $1 trillion a year, since the economy peaked in 2007.
There has been some demographic changes that reduced potential output over the past few years. However, that would take place slowly, not quickly.
We’re on a path where the destruction of potential output with the slow rise in actual output will eventually close the output gap and permanently shrink the U.S. economy.
Dannyb2b,
You are right about transferring the liquidity to the hands of the public in a measured way. And if liquidity was transferred into the hands of the public while raising the nominal interest rate, the adverse effects would be minimized.
Edward Lambert
The nominal rate would increase by itself if reserves were transferred to public. Higher demand for reserves due to substitution from deposits.
The zlb is artificial due to diminished functionality of reserves (cant be widely held or used for transactions). Look at broader interest rates they are nowhere near 0%
http://krugman.blogs.nytimes.com/2013/11/29/on-the-importance-of-little-arrows-wonkish/
November 29, 2013
On the Importance of Little Arrows (Wonkish)
Paul Krugman
“A new post by Stephen Williamson has both Nick Rowe and Brad DeLong fulminating — and rightly so. But my sense is that they are so shocked at the level of misconception on the part of a guy who imagines himself more sophisticated than crude neoKeynesians that they’re not managing to convey what’s really going on.
So let me take a stab at it.
Williamson has a lot of equations running around — fearful plumbing, as Rudi Dornbusch would have put it — but the essence of this story, whether he realizes it or not, involves movements in the Wicksellian natural rate of interest — the real interest rate that would match savings and investment at full employment…”
“…This should sound crazy to you: people become less willing to invest, seek the safety of government bonds, and inflation goes up? But why, exactly, is it crazy? Well, as Brad says, you shouldn’t have an economist’s license unless you understand at some level that when you’re writing down equilibria you have to have in mind at least some rudimentary dynamic story about how you get to those equilibria. In this case, you surely should at least implicitly have little arrows on your diagram:
[Diagram]
Right? Inflation rises when the real rate is below the natural rate, falls when it’s above the natural rate.
Is it easy to write down a fully-specified, microfounded model of those little arrows? No. But surely something like this has to be going on — or at any rate, whatever model you do write down had better be robust to some simple dynamic story about how you get to equilibrium. Otherwise you’re going to end up doing what Williamson is doing: comparative statics on an unstable equilibrium. Of course he gets bizarre results, not to mention completely missing the point that the persistence of positive inflation despite high unemployment is a supply-side, not demand-side question.
And the thing is that this sort of thing is showing up a lot — again, typically in the writings of economists who imagine themselves to be deep thinkers. As Rowe says, something has gone deeply wrong in the way macroeconomics is done in some places.”
Mark,
What you write there is the absolute truth.
“Inflation rises when the real rate is below the natural rate, falls when it’s above the natural rate.”
Yet, there is a problem. Mark Thoma’s recommendation is to increase demand from investment using tax incentives. He is not thinking deep enough. There has to be direct liquidity to labor. Labor share has to rise.
So in my mind, Mark Thoma lost the debate. And Mr. Williamson won because he was better able to explain what is happening.
I look through the past record of interest rate movements and inflation, and yes, the quote above is true. But then I wonder if the Fed was always tweaking the Fed rate in the short-run. What if the Fed just let the economy sit with the same interest rate for a long long time. Would the above principle still hold?
No… eventually the economy has to come back to its long-run natural real rate of interest.
In the 80’s, Volcker kept the real rate at 6% on purpose. It was an artificial manipulation with short-term responses. And then when inflation had abated, he changed policy to recognize a 3% natural real rate and GDP climbed back up.
But ask yourself this… Is there a difference between an artificially induced natural real rate and one that is considered truly natural?
How do know the difference?
Right now, Fed policy has forward guidance towards a natural real rate of -1% or so. Is that rate natural or artificial? and how do you know?
The idea seems to be that the “natural rate” is at equilibrium. That seems to be the definition of “natural rate”, but it is a problematic definition. Where is the argument that such a rate exists?
It also seems assumed that the equilibrium is an attractive equilibrium. There is no obvious proof for this. There isn’t even an obvious reason to believe this. Besides, even if that rate were attractive, we might not be in an attracted region. There may be no way to get there from here.
It also seems assumed that there is a unique equilibrium, that is, there is just one natural rate. Economists seem to assume this kind of thing all the time, which is why their mathematics seems stuck in the late 18th century. Euler could get away with this kind of crap because he was a f–king genius, but even he knew when he was taking a leap in the dark.
It’s been 200+ years. It’s time for economists to move in to the 20th century.
It’s amazing some people believe a severe recession or the collapse of the entire financial system is needed to close the output gap.
A bubble is needed in a depression. Praise the Fed for limiting the economic destruction.
Kaleberg,
Exactly… The natural rate could be what the Fed decides it could be.
I agree with you. That there may be no way to get there from here. This is what I think. I might be wrong, but my idea is that the Fed can set the natural rate below the effective demand limit, but they can’t do it much above the ED limit.
Volcker showed us that the Fed can set whatever real rate it wants and then push the economy toward that real rate. But that was done to lower natural GDP. Can natural GDP be raised? Keynes thought it might. Just keep the interest rate low. We will see…
And Mark Sadowski cites Krugman as someone who knows it all. I do not think that Krugman knows it all. He was wrong about living wages. He was wrong about why productivity is stalled. He was wrong about potential GDP. He was wrong about labor share. and Now he seems so illuminated by Piketty. But you know, Piketty’s work is simple and obvious. It surprises me nothing. These things were known and understood a century ago. How come Krugman is just now beginning to understand these things?
And Steve Williamson has an idea that is making sense. Once I combine my views on inequality, effective demand and labor share with his views on the Fisher equation, things make even more sense to me.
Let’s say that the economy reaches the previous potential GDP, and the Fed rate is 1.5% and inflation 2.0% with a real rate of -0.5%. But then we look around and see that inequality has blossomed into a huge ugly monster. Should we consider that success? No… I would hate to see Krugman gloating over how his model got it right, while giving lip service to the growing inequality.
“What if the Fed just let the economy sit with the same interest rate for a long long time. Would the above principle still hold? No… eventually the economy has to come back to its long-run natural real rate of interest.”
If you peg the interest rate above the Wicksellian natural rate you get disinflation. If you peg the interest rate below the Wicksellian natural rate you get accelerating inflation. The economy may come back to its long-run natural real rate but the nominal rate will not be the same.
“But ask yourself this… Is there a difference between an artificially induced natural real rate and one that is considered truly natural? How do know the difference? Right now, Fed policy has forward guidance towards a natural real rate of -1% or so. Is that rate natural or artificial? and how do you know?”
Money is neutral. It cannot change the long run real natural rate of interest. All it can do is change the long run nominal natural rate of interest.
Mark
If money is neutral in your opinion would that mean that an economy without money would be the same as one that used money? Money is of no benefit?
Danny,
“Neutrality of money” is an economic term. Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real (inflation-adjusted) variables, like employment, real GDP, and real consumption.
http://en.wikipedia.org/wiki/Neutrality_of_money
To be clear, I’m saying money is *long run* neutral. (You should be ablse to tell that from the context of what I am saying.) It is obviously not neutral in the short run. When I say money is “neutral” I’m stating a positive (value-free) fact, I’m not making a normative (value-laden) judgement.
Money’s other attributes, including its benefits, are largely independent of whether or not it is neutral.
I understand the concept of money neutrality. It seems flawed though.
For example imagine if money supply was fixed over short and long term. Due to productivity increases prices would deflate. This change in prices is causing uncertainty which is imposing costs on the economy.
On the other hand if money was expanded to create a stable price level 0% inflation then greater stability would ensue for forecasting etc…
It seems that if money achieves economic objectives more efficiently it actually increases rgdp.