Visualizing the Various Paths of Interest Rates & Inflation
Let’s go beyond the issue of the Fisher Effect and visualize the whole issue of nominal interest rates, real rates and inflation. The Fisher Effect is only a part of the whole issue.
So we start with a model that blends all 3 rates… nominal rates on the y-axis, real rates on the x-axis and each up-sloping line represents a different stable inflation rate…
The up-sloping line farthest to the left represents a stable inflation of 4%. As nominal rates rise, the real rate will rise too, since…
Real rate = Nominal rate minus inflation rate.
The lines to the right represent decreasing inflation and beyond into deflation.
The vertical dashed line is the Long run socially optimal natural real rate. The economy ideally will be at this vertical line for any nominal rate when it reaches full employment. The yellow star shows where the Federal reserve would like to be at full employment with an inflation target of 2%, a real interest rate equal to the Long run natural real rate of 2% and a nominal rate of 4%.
Normally in a business cycle, the nominal rate will rise as real rates rise… going up along one of the up-sloping lines. Let’s not get too far ahead of ourselves. You can probably already see this is a long post. Let me build the model more…
I have colored in areas of the graph to represent the constraints.
- The red area below a 0% nominal rate is not possible. It is the area below the Zero Lower Bound.
- The area to the left of the line for an inflation rate of 2% is hard to get to when inflation expectations are well-anchored as they are now… and the Federal Reserve will not tolerate much inflation beyond 2%. If inflation begins to rise beyond 2%, the Fed will react to push it back to the inflation target of 2%.
- The area to the right of the line for 0% represents the area of deflation. It is actually hard for inflation to turn into outright deflation. So there is an economic resistance not allowing inflation to become deflation.
So the interest rates of the US will most likely stay in the white zone in the middle of the graph.
Ok… Where is the US economy in this graph?
The US economy is at the blue star, which is stuck in a little corner between constraints with little room to move. Somehow the blue star would like to get to the yellow star. But how can it get there?
The Slopes of the Lines
The lines in the above graphs have a slope of 1. At constant inflation rates, a 1% rise in the nominal rate will lead to a 1% rise in the real rate.
- If the slope of the line is = 1, as the nominal rate rises, the real rate rises at the same rate as inflation does not change.
- If the slope of the line is < 1 (flatter), as the nominal rate rises, the real rate will rise faster than the nominal rate as inflation drops.
- If the slope of the line is > 1 (steeper), as the nominal rate rises, the real rate will rise slower than the nominal rate as inflation rises.
If a Central Bank raises the Nominal Rate, How will the Star move?
If the Fed were to raise the Fed nominal rate next month, the star would move along a line with a slope < 1. The real rate would rise faster than the nominal rate and inflation would fall. Hopefully we can all agree to this.
So then how has the Fed been able to raise the Fed rate in the past and reach the yellow star? Wouldn’t it cause disinflation and higher real rates that would choke the recovery? Well, past business cycles had momentum in their expansionary phases to the extent that the momentum would overcome the rises of the nominal rate.
Yet, the Federal Reserve now sees the recovery as fragile. The economic momentum is weak. There is much higher private debt levels and wage growth is going nowhere. Labor actually has much less consumption power. A rise in nominal rates could be too much for the economy and send it into a recession with falling inflation. The more rapid rise in the real rate would be too much for a weak economy.
You see the path that many fear if nominal rates were to rise too fast. Inflation would turn into deflation and the Fed nominal rate would have to retreat back to the ZLB in shame. It would be an ungracious recession.
What if the star was moved to the left?
To the left?… Are you crazy? That is a prohibited area. Yet this is the idea of top economists, such as Paul Krugman. They want to push inflation expectations higher allowing the real rate to fall even further. Then when inflation begins to pick up, the Fed can raise the nominal rate and the blue star will be flung back toward the yellow star.
The danger with taking this path is that once you open the door to higher inflation, you might just end up with hyper-inflation.
You can see the Fed tries to raise the nominal rate to cut off the rapidly rising inflation, but the slope of the line goes greater than 1 and inflation wins. Is this a real possibility? To many economists it is tempting fate too much.
Putting a Camel through the Eye of a Needle
So the trick to normalizing monetary policy and get back to the yellow star is to raise the nominal rate very carefully… if the economy responds with momentum you are “golden”, which means you have a chance of success. The only way for the economy to get back to the yellow star is to ride upon momentum.
As the Fed nominal rate starts to rise, the star takes the path with a slope less than 1. Inflation falls and real rates rise faster than nominal rates. Then the Fed waits for momentum. Will it come? Just wait… Let the economy find its strength to meet the challenge. But don’t be afraid of a little fall in inflation, like Sweden. You are still on the path to normalized policy. You are on a similar path to what has worked before in previous business cycles. But you have to just wait for the momentum to build on this socially-optimal path. The momentum should arrive to carry you safely and surely to the yellow star.
At some point, the slope of the line will have to turn greater than 1. There will have to be sufficient momentum and demand to support rising inflation. This is the Fisher Effect bringing the economy to its socially-optimum natural real rate. The Fisher Effect describes the periods when rising nominal rates coincide with rising inflation. Usually this happens at the end of a business cycle when output reaches its natural level, and where economic momentum translates into inflation instead of higher output.
There is a synergy of economic activity as the economy approaches the yellow star. This is the Fisher Effect. Inflation tends to want to rise around the yellow star at full employment. At least that has been the experience in past business cycles. If the momentum never comes, then there really was no hope of ever getting safely back to the yellow star in the first place.
What does it mean to be “Behind the Curve” in monetary policy?
In order for the blue star to go to the yellow star, there has to be enough time and spare capacity which is consumed along the way. So a Central Bank has to start moving nominal rates toward the yellow star early enough in the business cycle in order to have enough fuel (spare capacity) to get there. If there is not enough spare capacity, then momentum will not build well enough. The Central Bank would not be able to raise nominal rates without the rise in real rates overcoming the lack of spare capacity. The economy would fall into a recession with disinflation and maybe deflation.
The Fed must be careful with a delicate economy that has been abused by the rich creating inequality and weak effective demand from labor. But is the Fed being too careful? The longer the Fed waits to raise the Fed rate, the more spare capacity is consumed. The less fuel there will be for completing the trip to normalized monetary policy.
“The danger with taking this path is that once you open the door to higher inflation, you might just end up with hyper-inflation.”
(Only if you are completely stupid and don’t adjust policy as you go along.) The economy is not so fragile as you (and the Austrians) seem to think it is.
Note all the assumptions you make
1. That hyperinflation just happens easily (no it takes real supply side problems and massive increases in the circulating money supply). I don’t understand what you mean by the slope of the line becoming greater than 1. The line is at 45 degrees by DEFINITION. I guess you mean that inflationary expectations accelerate rather than shift. But it seems to me getting them to shift at all at the moment is damn difficult (although Japan managed it at least temporarily).
2. That there is an “ideal long run real rate of interest”
(rather than just looking for a real rate of interest that matches ex-post savings and ex-ante savings – somehow you never identify what the problem is that we are trying to solve). But notice also that you place the yellow star on the 2% line. But if you increase inflation expectations, the yellow star will also move (further to the right). All your arrows are wrong.
Oops
The yellow star will move further to the Left. And what does it actually mean to be left of the line (i.e. with very high nominal rates and low real rates). It simply believes that expectations of inflation are very high. But that only happens if nobody believes the Fed can reduce inflation. But we KNOW the Fed can reduce inflation.
Edward,
I believe that there is a flaw with your description of the interaction between the economy and the Fed. Our experience over the last almost 7 seven years leads me to believe that the Fed cannot create momentum. And I believe that once momentum is lost, it can only be recreated by a healthy economy.
First let’s make sure that we are on the same page.
Judging by our post WWII economic history the Fed is empowered when the economy is operating within some normal range. (Whatever normal is.)
If the Fed recognizes that inflation is too high, it raises interest rates, which decreases borrowing, which decreases discretionary purchases, which causes producers to layoff employees which should decrease GDP as they spend less. (Remember Paul Volker)
If the Fed recognizes that inflation is too low, it lowers interest rates, which increases borrowing, which increases discretionary purchases, which causes producers to hire employees, which should increase GDP as they spend more.
The Fed can reduce inflation because they can raise interest rates to 20% or whatever. I can not imagine an exception other than a cash economy with no borrowing.
But the Fed can not always increase inflation. Specifically when the Fed Funds Rate is reduced to 0%, then they are no longer in the drivers seat, they are passengers. At 0%, they should be creating sequential bubbles. And they are now, first in the stock market but then over the two years there were corporate investors buying up houses to repair and rent but it has become obvious that was a flawed idea and there are less and less cash buyers. So now they are back in the stock market. There has been some talk of negative nominal interest rates but that would cause all kinds of distortions to the economy. The price of banks’ safe deposit boxes would increase and back yards and mattresses would become the safe deposit boxes for those earning less than the median income.
Now on to your momentum problem.
You write: “As the Fed nominal rate starts to rise, the star takes the path with a slope less than 1. Inflation falls and real rates rise faster than nominal rates. Then the Fed waits for momentum. Will it come? Just wait… Let the economy find its strength to meet the challenge. But don’t be afraid of a little fall in inflation, like Sweden. You are still on the path to normalized policy. You are on a similar path to what has worked before in previous business cycles. But you have to just wait for the momentum to build on this socially-optimal path.”
There is always some momentum but now it is very low. When the Fed increases interest rates that decreases borrowing, which decreases discretionary purchases, which causes producers to layoff employees which should decrease GDP as they spend less. So you have reduced momentum even further. The economy will still grow but even slower than before. First you will have to overcome the loss in momentum you just caused and then wait for an increase in momentum which would allow you to raise rates again. You certainly can not reduce rates because then you would be right back where you started when you raised rates. That would only be an admission of an error in policy.
I believe that economists have come to depend too much on the Fed. They want more than it can deliver. The Fed is part of a feedback systeml which only works over a limited range and we are no longer in that range. Now we have to make real repairs to the underlying economy. I favor increasing labor share and permanently reducing personal debt by government policy. But anything other than directly improving consumers’ economic health is doomed to fail.
Hello Reason,
I am not advocating the hyper-inflation route. I add it into the post to show what others are thinking. I do not believe that hyper inflation would result if the blue star moved to the left. There simply isn’t enough strong demand.
So hoping for inflation to lead the way is not a solidly logic approach to normalizing policy. Demand is weak partly due to low nominal rates. Lenders are more resistant to lend. They receive less return. There was an article today about how lending to noncorporate entities has been slow since the crisis.
http://www.stlouisfed.org/on-the-economy/credit-to-noncorporate-businesses-remains-tight/
So if nominal rates were to rise, banks would be more willing to lend to cover their risk. But income streams in non-corporate sectors have become thinner in the aggregate. So it is tricky even raising nominal rates.
In the end, normalizing policy rates will depend on being able to ride upon economic momentum… We have seen economic momentum this year but policy rates let it go by…
JimH,
I read your words and I agree with everything that you said…
Yet, I look at your idea that ” the Fed cannot create momentum”. Then as I read your words, the Fed can only decrease momentum by raising rates. I agree that is true in the short run, but if it is more socially optimal in the long run, momentum will appear.
it is like minimum wages. There is a socially optimal level. If minimum wages are below that level, then you raise minimum wages toward the socially optimal level, you will see decreased momentum in the short run, then you will see increased momentum after.
So in effect, the Fed can create momentum by raising nominal rates… but you have to wait beyond the short run effects. The economy has the power and capacity to continue to expand. And it will…
As I see it, low nominal rates are not optimal because there are distortions in the market. As nominal rates rise, those distortions begin to disappear. Momentum begins to coalesce through better balance.
So the Fed can create momentum even by raising nominal rates, but it is beyond the short run effects.
I should add that driving real rates lower has its risks. That would be the path recommended by Krugman. Lending would pick up in the short run as the real rate goes lower with some rising inflation (blue star moves to left), but as soon as the real rate stops falling, lending will subside again. If nominal rates start to increase at that point, the blue star will be moved back to a lower inflation rate implying that real rates would rise. As real rates rise, you would see lending slow down. There is a good possibility that the blue star would just end up back where it is now. It is not the best way to generate momentum…
My view is that moving the blue star on the socially optimal path is the best way to generate momentum.
Imagine if the minimum wage was lowered in order to generate more employment in the short run, then as the labor market tightens, there is pressure to raise wages… ok, then the minimum wage will be raised even higher than before and everything will be ok, right? Well you would have to raise the minimum wages much faster this way after lowering it. That creates unneeded stress in the labor market. It is better to just raise the minimum wage carefully toward its socially optimal level and let the labor market adjust along the way.
Edward,
I do not view the minimum wage as economic policy, I suppose you could say it is related to fiscal policy. People must have enough money to live in our society. If we want less government welfare payments then jobs must pay the poorest among us more than they could bargain for in the current free market. But any increase in the minimum wage comes at the expense of more highly paid consumers in the economy. Common sense dictates a minimum wage and morality reinforces that.
I do not see any equivalence between the minimum wage and the Fed Funds Rate. The Fed Funds Rate is a feedback mechanism used to keep the economy within some normal range of operation. It benefits everyone if it is wisely adjusted.
You wish that the Fed could create momentum in the long term, in spite of raising the Fed Funds Rate. But in the long run producers would see through the manipulation. They would look at their own underlying economic data and refuse to increase production. In fact the overhead from increasing interest rates could force them to raise prices. But consumers can not spend what they do not have and so any price increases would tend to cause consumers to reduce discretionary spending. And if consumers trimmed discretionary spending, producers would be forced to reduce production. Thus my theory that you would reduce momentum if you raised the Fed funds rate.
Your idea about lowering the minimum wage has similar problems and results. I accept that lowering the minimum wage could increase employment but I believe that some employers would just pocket the money and not try to increase their business in a poor economy. So you would get a net loss in discretionary spending.
I agree that excessively low interest rates cause problems in the economy. (i.e. bubbles) And so I favor raising the Fed Funds Rate even though that would slow the economy further. In addition to attenuating bubbles, I believe that it would also give us a better indication of the poor health of the real economy. Perhaps that would force the ‘powers that be’ to accept that real changes have to be made and sooner rather than later.
Our real economy has been damaged. It will have to be repaired and that will mean a rebalancing of interests. It will be painful to those who have benefitted by a system tilted in their favor.
Or we can continue to thrash about, searching for that perfect solution, making everyone happy and costing everyone nothing. But seven years of futile searching should be enough.
JimH,
A low minimum wage is known to be a subsidy to higher paid consumers. It is not socially optimal.
I use the minimum wage as an analogy for increasing a cost toward a socially optimum level. There are many other examples, like Pigovian taxes, public use fees…
You would reduce momentum in the short run with a rise in the Fed rate, but the economy has overcome these rate rises in the past.
I agree with your last 3 paragraphs.
Edward,
You wrote: “A low minimum wage is known to be a subsidy to higher paid consumers. It is not socially optimal.”
I can not bring myself to oppose something because it is not ‘socially optimal’. Who is to judge what is ‘socially optimal’? The best defense of a reasonable minimum wage is that we will either pay a higher minimum wage or we will be forced to pay government welfare benefits to make up what recipients need to live in our society. As a society we are not willing to kill the poor, we are not willing to see them starve, and we are not willing to see the government imprison them for their poverty. Any educated society should understand that mere existence breeds crime thus at some point you have to accept that working people will have to be paid some reasonable minimum wage. In my opinion, today it is too low.
You wrote: “You would reduce momentum in the short run with a rise in the Fed rate, but the economy has overcome these rate rises in the past.”
Yes the economy has overcome higher Fed Funds Rates in the past but remember that the Fed raised rates at times of high inflation which almost always occurred during boom times. The exception was during the 1970s when the price of oil was driven by an unregulated external cartel and the price of oil drove inflation higher and higher in a less than booming economy.
I don’t trust easy answers. They are almost always an attempt to avoid an unpleasant truth.
I repeat “Our real economy has been damaged. It will have to be repaired and that will mean a rebalancing of interests. It will be painful to those who have benefitted by a system tilted in their favor.” But even they will benefit in the long run. They will get a smaller piece of a larger pie.
US corporations rushed to get into the newly opening markets in Russia and then in China. Global Free Trade meant that they could send products back to the US with low tariffs. But it has become apparent that the Russian idea of the rule of law is not what Americans expected. And China is no better. The theft of intellectual property is rampant.
Here is one of the latest shots across the bow of American corporations:
Bloomberg 15 Sep 2014: “Treasury Secretary Jacob J. Lew said in the note to Vice Premier Wang Yang that China is using competition law to force companies to cut prices its consumers pay for products relying on foreign intellectual property, according to a person with knowledge of the correspondence. Lew said such steps might have consequences for bilateral ties, according to the person, who asked not to be identified because the letter isn’t public.
Lew’s complaint follows criticism from the main U.S. and European business lobbies in China that authorities in the world’s second-biggest economy are discriminating against non-Chinese corporations. Dozens of foreign companies are being targeted in probes, with regulators opening an anti-monopoly investigation into Microsoft Corp. (MSFT) in July and state media accusing Apple Inc. of using its iPhone to steal state secrets.”
China wants to get into the higher technology businesses. To do that they will need access to American or European technological knowhow. They will force ever closer partnerships until their domestic corporations have access to that knowhow. Then American corporations will be forced to compete with their own technology when it is exported to the US.
American corporations need to act in their own long term self interest. That is difficult with a stock market operating on quarter to quarter assessments but it will have to be done. Their technological knowhow is not safe in China or Russia.
JimH,
I agree with you on China. They do not accept foreigners into their identity.
Also, my views on socially optimum levels is based on my training in physiological homeostasis. It can be said that every disease is a result of some failure in homeostasis in the body. I would definitely say the same thing about the economy.
The economy is sick, therefore the system as a whole is out of balance homeostatically. That means either certain functions are broken, or regulatory functions are broken, or systems communications are broken, or the center of system control is not functioning well.
The Fed rate is like a center of system control. The transfer mechanisms to the general economy are like systems communications. The weak labor share is a system itself that is out of balance.
Edward,
I just saw that you wrote this:
“So if nominal rates were to rise, banks would be more willing to lend to cover their risk.”
What have nominal rates got to do with it? Banks make their money on margin (i.e. on pricing risk) – the rates they LEND at, are something they can decide themselves. The problem is not the nominal level of interest rates, it is the size of the risk premium they demand.
Look, I know that in a way your style of argument is modelled on what comes from right-wing economists – especially “Austrian” economists but I really find it hard to warm to arguments about finance that don’t use the words expectations or risk. Finance is about perceptions of the future and expectations and risk aren’t just side lights – they are the main story.
Reason,
Low nominal rates is a big problem for banks in Europe, more so than in the US. They are less able to make profit. There is talk that raising nominal rates in Europe would benefit the banks.
That is what I am referring to.