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.
Williamson, Stephen. Phillips Curves and Fisher Relations. Stephen Williamson: New Monetarist Economics. December 15, 2013.