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.
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)
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.
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.
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.
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.
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?