Defending higher nominal Fed rates… response to Mr. Thoma
Mark Thoma wrote that the Fed should not have already raised its nominal Fed rate. He wrote that justifications for already raising the Fed rate are misguided. Now I am one who is saying that the Fed should have already raised nominal interest rates for two reasons…
- Potential output is lower than people think which raises the Fed rate determined by the Taylor rule.
- According to the Fisher Effect, inflation will follow nominal interest rates when the Fed rate is held constant or bound within a tight range for a long time.
Potential Output
When potential output is lower, the output gap to full employment is lower. According to the Taylor rule, a smaller output gap leads to a higher nominal rate. As the output gap closes at full employment, the nominal rate should return to its long run normal rate.
Thus I see that the Fed nominal interest rate would need to return to its “normal” level sooner. (Normal means natural real interest rate + expected inflation target, r + pe.) The normal nominal Fed rate is roughly 4%, based on a real natural rate of 2%, and the inflation target of 2%.
Here is how I see potential output (red line in graph)
Graph #1
Potential output has fallen to a new trend line since the crisis and is holding steady. This video explains how I determine potential output. I show that the government has been wrong about potential output. Likewise, they keep revising potential output downward but I can see how far down they really should be revising it. I have not had to revise my determination of potential output, as real GDP is trending steadily along my potential output.
Fisher Effect
Mark Thoma mentions the Fisher Effect, which uses the Fisher equation. i = r + pe. Nominal rate (i) is equal to real rate (r) + expected inflation (pe). As Mr. Thoma says…
“Some economists have argued that when policymakers hold the nominal interest rate at the zero bound, it is deflationary since r is positive, and pe = -r when i=0.”
Mr. Thoma is responding to an error in logic that assumes that the Fisher effect is currently deflationary. I am not saying that the Fisher effect is deflationary, because I foresee the nominal rate rising above the natural real rate as we move toward full employment. Thus inflation will be low, but not deflationary.
However, the Fed has projected a Fed rate well below the “normal” rate. Mr. Thoma says…
“Although there have been many calls for the Fed to raise its target interest rate, the Fed has made it clear that it intends to keep its target interest rate abnormally low even after the economy is well into recovery. There may be some risk of inflation in this approach, but as noted above this risk appears to be small.”
Keep these words in your mind as you read on… “abnormally low“. According to the Fisher effect, inflation will stay low too, because inflation moves with nominal rates in the long run. I need to untangle a little error in Mr. Thoma’s logic. He says…
“If the increase in the nominal interest rate is not accompanied by an increase in inflationary expectations, then the Fisher equation tells us that the real interest rate will rise. That would be very harmful to an economy struggling to recover from a recession.”
He implies that inflation expectations would not rise with an increase in the nominal rate. He implies that nominal rates and inflation do not move together. However, we are witnessing a situation where inflation is moving with nominal rates; They have fallen together. This is happening in Europe too. Therefore the real rate in the long run is holding steady, as the Fisher effect says. One must open up their mind to the possibility that an increase in the nominal rate will be followed by an increase in expected inflation over time. Yet, he can’t see this…
“…it’s hard to see how an increase in the nominal interest rate would cause people to expect an increase in demand and a subsequent increase in prices.”
This is where economists cannot understand the Fisher effect. They cannot see a scenario where an increase in the nominal rate leads to higher prices. They only see as far as a higher nominal rate would decrease demand, which as he says would be a “disaster”. They only see as far as the monetary shock as Mr. Krugman did over the weekend. They do not see that the shock wears off, and then the Fisher effect takes over. They do not see that in order to escape from this “low nominal rate – low inflation rate” trap, we need to be like a little chicken breaking through its shell. If we do not break through the shell, we will never leave the Fisher effect holding down inflation. Just look at Japan.
So how does a higher projected nominal rate lead to higher inflation over time?
We have a situation where business is projecting an abnormally low Fed rate even at full employment. The implication is that inflation will have to naturally be lower since the real rate holds steady.
Let’s suppose that in the aggregate, business is projecting a 1% natural increase in output. That is the natural real rate underlying aggregate macroeconomic conditions. Then they see a long run Fed rate of 2%. In the aggregate, inflation will conform to 1% through contracts of pricing and wages.
If people in the aggregate expected an inflation rate of 1%, more people would enter into contracts knowing that inflation would not take away their expected return. Even people who benefit from a higher expected inflation would still enter into contracts. As more people reach for yield, getting a balanced inflation expectation is essential to contracts. Here is a graph for the additional expected returns after figuring in real rates and inflation.
Graph #2
The market will optimize in the long run at an expected inflation of 1%. It is safe to do so because the Fed guarantees abnormally low nominal rates.
Now, if the projected nominal Fed rate was 3% instead of 2%, what would happen? Then a 2% inflation would give the aggregate equilibrium to optimize people entering into long run contracts. Here is a graph.
Graph #3
The higher projected nominal Fed rate allows for a higher expected inflation equilibrium.
The key is that people are basing contract decisions upon the more reliable factor of the Fed rate. They know that the Fed rate will stay low, more than they know what inflation will be. Thus they feel safe in the aggregate to negotiate pricing upon the projected Fed rate and expected increases in output. In the aggregate, people feel safe seeing low inflation with long run low nominal rates.
So through time in the aggregate, inflation expectations are optimized to projected nominal Fed rates and the underlying real rate… This is according to the long run Fisher effect.
Noting the Difference between Short run and Long run movements of inflation
The above is looking at the long run equilibrium when the nominal Fed rate is seen as stuck within a tight range of movement. Policy rate shocks are taken out of the equation. So inflation adjusts to that range over time. However, as Mr. Thoma implied, the short run can work against you. Here is a graph of how inflation responds to the nominal Fed rate in the short run and in the long run.
Graph #4
In the short run (orange line) policy rate shocks create an opposite effect in inflation. If the Fed rate was to unexpectedly rise now, inflation would fall from a negative demand shock. However, in the long run (blue line) and in the absence of further unexpected policy rate shocks, inflation will go to the Fisher effect equilibrium. And the higher the projected nominal Fed rate, the higher the equilibrium expected inflation.
The red dot to the left shows where we are now. (Fed rate = 0.15%, inflation = 1.5%) The red dots to the right correspond to graphs #2 and #3. You will notice that the movement of inflation going to the right is down first, then up. The initial down movement is what scares economists. They think it will create a recession. Yet, they are not looking deep enough at the dynamics. If you raise the Fed rate properly and carefully with balanced expectations, you can minimize the downside impact on inflation.
The slope of the short run change in inflation (orange line) was more horizontal a couple years ago. Price levels had a momentum to hold steady with nominal rate increases. When expectations of the projected Fed rate are balanced, the slope is more horizontal. There is less downward movement in inflation. Yet, now the slope of the orange line would be steeper. Fed rate increases would have a larger short run negative impact on inflation. Thus the best policy for nominal Fed rates is to start early and raise them steadily toward their natural level.
So I refute Mr. Thoma’s premise that nominal rates should not have risen earlier
Mr. Thoma’s primary premise was that nominal interest rates should not have risen before, and should still stay low. Yet, earlier was the best time to raise rates. The economy had momentum to keep on growing. Now we are simply too close to the end of the business cycle. Profit rates are already peaking. The economy would most likely suffer a larger hit from an unexpected rise in the Fed rate.
I think he has a fear of raising the nominal Fed rate to where it needs to be. And his fear is justified because the dangers of raising the Fed rate have continually increased. Mr. Krugman shares his fear.
Yet, in order to break this cycle of low inflation with low nominal rates that the Fisher effect describes, at some point we will have to raise the Fed rate back to its normal and natural level. We should have started that process earlier but there was little hope of that since calculations of the output gap were so wrong. However, we will have to do it at some point. The only option Mr. Thoma gives us would be after the next recession, but the fear of raising the Fed rate to a normal level would probably still exist… We are Japan, aren’t we?
One thing bothers me about the whole inflation expectations thing, the word expectations. What does that mean? It’s not as economists can actually predict inflation in the sense of at one point in time stating the inflation number for some future point of time and that at the future point in time having the actual inflation number be somewhat close to the number stated earlier. As far as I can tell, the inflation expectation is more or less defined as the difference between the real and the nominal rates of inflation, but that leaves us with defining the real inflation rate. The nominal rate we can measure. The other two are just numbers people make up.
Now, it might not matter what value is chosen as the real inflation rate or the expected rate. All the math might work out fine, but if an analysis is sensitive to the chosen value, it would be nice to know how it is chosen.
Some years back the book Science Made Stupid explained how meteorologists came up with those probabilities of rain by using a rain probability gauge. It worked by using a float to measure the probability level, then divided by the actual precipitation or something like that. Whenever I hear an economist talking about expectations, my mind wanders back to that rain probability gauge.
I look at the gas pump to determine my rate of inflation.
Kaleberg,
Everyone has an unique expectation of inflation. But if you bundle them all together, there is an average.
Now when you establish contracts or even inflation derivatives, you have to have an idea of what inflation will do. You have a prediction, which is your expectation.
However, let’s say you expect 0% inflation and your borrowing opportunity costs are 3% interest and your business real output grows at 2%. In the absence of inflation, you are losing 1% on your borrowing. So then you try to raise your prices 1% to make up for your cost of borrowing. That creates inflation.
On the other hand, what if you expected 2% inflation, your borrowing opportunity cost is 3% and your business real output grows at 2%. You are gaining 1% on your borrowing. You can lower your prices 0.5% and still gain on your borrowing. That creates lower inflation.
Now, imagine you expected 2% inflation, your borrowing cost goes lower to 2%, and your business real output grows at 2%. You are now making 2% on your borrowing. You could actually lower your prices 1.5% and still have a positive gain on your borrowing. That creates even lower inflation. And with lower effective demand, there is an incentive to lower prices.
And this is what we are seeing now as the projected Fed rate goes lower and lower.
Expectations can change just to make your business more profitable. You may expect inflation will go higher, but you lower your prices because it is profitable. Others do the same even though they too think inflation should go higher. And yet, strangely inflation is falling as profit rates rise.
Edward Lambert,
First let me confess that I have never understood the perceived importance of the Fisher Effect. I see no underlying enforcement mechanism in our economy. It appears to be nothing but a backward glance at the past, an idle curioscity.
Which comes first, low inflation or lower nominal interest rates? Low inflation seems to happen when too few dollars are chasing too many goods. When this happens, GDP growth slows and the FED rushes in to lower interest rates. The result is increased borrowing. And spending increases so as to purchase some of those ‘too many goods’. (Until the vast majority of consumers have reached their credit limit!) Looking back we would see inflation and interests rates following a similar path. The FED has been ‘rushing in’ since the end of World War II. And as GDP growth recovers, the FED increases interest rates to a level consistent with “normal” levels of inflation. This easily explains the interaction between inflation and interest rates.
In my opinion, the vast majority of consumers have little or no expectations about inflation levels in the future. They live on the income that they earn this year, quarter, month or week. They gain nothing from long involved speculative musings about future inflation. If they received a pay raise they would purchase a little more, until prices rose and then cut their spending back to the necessities. They save a few dollars here and there but at the end of most years there is little left over. At the end of several years not much more has accumulated. The middle class earns more but that money ends up in a college or retirement fund and thus it certainly won’t be consumed today. When the middle class raids those funds it is a sign of desperation, they are eating their seed corn. This ‘vast majority of consumers’ is the largest part of our economy.
The Japanese have real problems in their economy which they have not addressed. Ignoring their short term problems like the Fukushima disaster, they have had very serious long term problems competing with the rest of southeast Asia for the American and European consumer markets. Eventually they will have to lower their standard of living or find some way of convincing Americans and Europeans that it is not in their long term best interests to trade with China or Vietnam or any number of other exporters. Until then they will be twisting in the breeze.
We Americans also have real problems in our economy which we are not addressing. Since about 1984 we have allowed labor’s income to stagnate. This was ameliorated by labor spending down any savings and accumulating debt. Then the inevitable happened when consumers reached their credit limits and consumer spending had to fall. And as fewer transactions occurred the velocity of money started to decline. Eventually we will lower our standard of living or we will do whatever it takes to increase labor share. Until then we will be twisting in the breeze. Unlike the Japanese, we control our own destiny.
It is way past the time to stop trying to artificially stimulate the economy. Raising interest rates would also tend to reduce the speculation on one asset or another. Raising rates will come with a price but we have been masking reality, and it is time for the truth. Perhaps the truth will force the ‘powers that be’ to increase labor share.
I don’t need the Fisher Effect to come to this conclusion.
JimH,
You know I fully agree with you on labor share.
Yet, the fisher effect holds in the long run. You can push the economy away from its equilibrium and call the consequences good, like China does or other emerging countries. But when the US goes away from its Fisher equilibrium, its not a good distortion of the economy. Along with labor share it is another problem that has to be fixed.
This, for me, at least, was one the the most intuitively understandable posts you’ve done. It really explains how individuals’ reaction functions — what they’re thinking will happen and how they react to that — plays out in the economy.
Microfoundations! 😉