Fisher Effect in Econoblogosphere again
John Cochrane is developing a model for the Fisher Effect to explain that raising the nominal central bank rate could lead to higher inflation, not lower inflation as many say. Nick Rowe complements the model with a simpler “model”. And Steve Williamson has been an ever-present force for the Fisher Effect. I too have written about this before (link).
I also wrote in June (link) that the extra loosening of monetary policy by the ECB in Europe would be a test of the Fisher effect. Since June, we have seen inflation expectations continue to fall, which supports the Fisher Effect.
Once you realize that firms hedge against extra funding costs by raising prices as I see, and that a rise in the nominal rate is a rise in the money growth rate as Nick Rowe explains, and that coordinated fiscal-monetary policy produces the Fisher Effect as John Cochrane sees… then you see why nominal rates should not fall but rise in order to raise inflation.
Raising the nominal rates by central banks would also increase consumption. John Cochrane and Nick Rowe talk about this.
- John Cochrane…”In the meantime the higher real interest rates (green) induce a little boom in consumption. So, raising rates not only raises inflation, it gives you a little output boost along the way! “
- Nick Rowe… “Now remember the relationship between consumption and real interest rates from the standard New Keynesian Euler equation. There is a positive relationship between the level of the real interest rate and the growth rate of consumption.“
I presented a video one year ago here on Angry Bear in response to a post from Nick Rowe that talked about how consumption would increase from a rise in nominal rates. The video gave a model of a bifurcated money market between labor and capital where lower interest rates were causing bond prices to rise, inflation to fall and GDP to fall. The bifurcated money market is due to the divergence in money supply between labor and capital income after the crisis. The model supports what Cochrane and Rowe say about a boost in consumption from raising interest rates.
We have had an environment that greatly favors the Fisher Effect to raise inflation and consumption by raising nominal rates… but I think time
is running out has run out on this option.
The fact that this is still debated is quite scary. Clearly, economics is not science.
I think economics is a science. Yet, there are still many unknown mechanisms that are conditional in nature. If you get the right conditions, mechanisms will have different outcomes. Saying that raising the Fed rate would always lower inflation is too narrow-minded. The scientific dynamics of the mechanisms within various contexts need to be looked at.
Regardless of what formulas you use the only thing that happens with QE is more cheap money for the financial markets to gamble in the stock market. The only thing that will raise spending by the 80% is jobs, capitalists do not spend or expand till the 80% have money to spend.
I have no respect for John Cochrane, little for Steven Williamson but quite a lot for Nick Rowe. So in general I be careful of the company you are keeping. But the key thing is that you mention “dynamics” whereas I’m pretty sure the models in question are equilibrium models (which do not explain how the equilibriums are reached).
How do you get to the natural real rate equilibrium? This is the question… Can it just be ignored and stomped upon as if it is no more than an ideal in the minds of idealists?
Is the natural real rate (real rate equal to natural real rate at full employment) an equilibrium? This is another way to state the question.
What forces try to push the real rate to its natural level? We know that GDP will head toward its natural level and then there are forces to keep it there if it tries to go too far beyond it.
We know that unemployment has a level at full employment too.
But does the real rate want to head toward its natural rate too?
And if so, how does it do it?
Normally the Fed rate rises at the end of a business cycle bringing the real rate to its natural level. But the Fed is engineering that process. Would the real rate head to its natural level if the Fed just let the market determine the real rate? This is another way to state the question…
The natural real rate should coincide with the equilibrium steady-state at full employment. The natural real rate represents the real growth of the economy. On average and in the aggregate, returns on the economy should coincide with the real growth of the economy. Such that, if I invest in the economy, my real return will be the natural real rate over time. And if I borrow from within the economy, my real cost should be the natural growth rate of the economy. Such that, on average and in the aggregate, my business grows at the natural real rate.
Then when the economy reaches the steady-state at full employment, the steady-state can be maintained because lending and borrowing costs are in line with the natural level of output.
Yet there are factors that distort the real rate from reaching its natural rate… forces that want inflation or disinflation, Fed actively determining rates in the market, growing imbalances of liquidity within growing inequality…
Can the real rate head to its natural rate in spite of these forces? … It tries, but is not always successful.
The Fed can overpower the real rate, but this time the Fed is powerless due to the zlb, and we see the real rate trying to creep up to its natural level. So inflation has to fall in order for the real rate to creep up… but are there forces to raise inflation like lots of money in the hands of consumers? No, labor share is low. The power of consumers to raise inflation are constrained. So then why does inflation fall? Is it because the forces to push the real rate to its natural level are winning or just because the economy is stronger on the supply side than the demand side?
So we imagine an economy at full employment with the real rate 3% below its natural real rate. What do we see? The economy can grow below its potential because it only has to satisfy a lower real rate. The return on investment can be lower because the real cost on average and in the aggregate is lower. The risk premium rises on lending to business which simulates a higher nominal rate, but the base real rate stays low.
So a real rate that is much lower than the natural rate can undermine the economy to reach its full employment potential.
The other side of the coin is what Volcker did. He used the Fed rate to actively raise the real rate far above the natural real rate of 3%. He manufactured and then maintained an artificial real rate at 6%. This high real rate also weakened the economy and created a premature recession in the business cycle.
My view is that the economy performs much better, in something like a homeostatic synergy, if the real rate can be at its natural level when full employment is reached.
The real rate would have to rise 3% to return to its natural rate… and we are reaching full employment about now. And the economy is sick.
If you watch the video above in the post, you will see that the labor income market wants a higher interest rate to get into equilibrium. They want to save. They are trying to save but are frustrated. They cut back on spending because they are wanting to save. That is where there equilibrium is in the money market. A low real rate now suits the changes that capital income is going through, but not the demand side of consumer and labor. The key is to raise the real rate to shift the money demand curve in the labor money market with a higher nominal GDP, which will translate into more inflation. You would see a boost in consumption with a higher rate. You would see prices start to rise to hedge against the cost of higher rates. You would see labor start to consume more to hedge against future price rises. Then the whole process starts to feed upon itself with more consumption, higher prices, inflation, and then more investment. And before you know it, the economy has healed itself by raising the real rate towards its natural level.
The key is to follow the wisdom of physiology… specifically homeostatic synergy. The body is healthier and more energetic when physiological factors are not too low or too high, but balanced in homeostasis.
Keeping the Fed rate low is creating a sub-par homeostatic situation. It is like forcing food into a body to give it more energy. Yet energy really comes from homeostatic balance and not food.
“If you watch the video above in the post, you will see that the labor income market wants a higher interest rate to get into equilibrium.”
This sort of anthropocation of markets really annoys me. Markets don’t want anything (they aren’t things for a start, market is a collective term – markets consist of actors who want different things).
People want to save more. But they are frustrated by a low interest rate, which is trying to make them consume more. They do not want and they cannot consume more. Thus, a higher interest rate for the masses would be better.
SOME people want to save more, but they are frustrated because OTHER people also want to save more and people can only save if other people spend (because one man’s income is another man’s spending). The low interest rate reflects the reality that everybody is trying to save at once, so that saving is in terms of the economy as a whole, an undesireable thing to do.
And as for the modelling – Nick Rowe has a new post up:
(But modelling is just modelling – it doesn’t tell you about reality which is my main beef with Steve Williamson who has problems with that idea. John Cochrane is just arrogant and slightly mad.)
In the money market graphs I show, you do not see saving vs. spending. You only see liquidity preference. Do you choose to put your money in liquid accounts or accounts where your money gets tied up for a longer time.
The low interest rate reflects the Fed’s choice based on a belief that there is still great spare capacity out there. Yet I see that this spare capacity will be unusable due to the effective demand limit. We are seeing signs of that now.
So in the money market, if you allow ordinary people to save money at a higher interest rate, they will feel more secure with their money. They want a higher interest rate. As it is with a low interest rate, they have too much demand for liquid money that makes them feel insecure. So they try to save at horribly low rates.
If you raise the interest rate, people will feel more secure, then they will spend more. That is when the money demand curve shifts right to a higher level of nominal GDP. Then you would see the money market move toward a better equilibrium for Main Street, and thus for Wall Street too.