What goes down must come up…


Michael Hatcher and Patrick Minford have a post titled, Inflation targeting vs price-level targeting: A new survey of theory and empirics. They tell us that Price level targeting may be better than inflation targeting, because if inflation goes down, it would bounce back over the Fed inflation target. Inflation targeting just brings inflation back to target. The benefit of price-level targeting is higher expected inflation in the future and consequently lower real interest rates. The lower real interest rates are good to encourage more investment. End of story, right?


Now let’s suppose that real interest rates are independent of monetary policy as the Fisher Effect would say. The implication is that real interest rates should in the long run reflect real economic growth. Therefore, real interest rates at some point in the future would also have to bounce back over their natural rate after being pushed down. And if the natural rate is 2% let’s say, real rates will have to bounce back to maybe 4% for a while. Thus if we have a 2% inflation on average, that would mean having a 6% nominal Fed rate as the norm for a particular time in the future.

Well, the Fed is projecting low nominal rates for quite some time. This is the problem in the post by Hatcher and Minford. They assume the Fed rate will stay unnaturally low to boost economic growth. But when would the real rate be able to bounce back higher than its natural level of 2%? and How?

We have a situation where the range of the long run Fed nominal rate and the real rate are already projected. Therefore future inflation is determined from them. Basically is not that easy to push real rates down when the Fed rate is at the zero lower bound and unable to directly effect inflation.

I get the sense that a steady-state sustainable type economy is not appreciated. We see continual attempts to manipulate away from what is natural. It only creates chaos later.