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Here’s Noah Smith:

First, the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation: R = r + i That’s not an assumption, that’s just a definition (actually it’s an approximation, but close enough). What I call the “Neo-Fisherite” assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Noah Smith is making a very subtle error here, but before getting into the details let’s blow the neo-Fisherite model right out of the water. We can do so with a couple points made in the comment section. First Nick Rowe:

Here is one very big bit of empirical evidence against the “Neo-Fisherite” theory: For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%. The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate. If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

No, they aren’t lying. And if you don’t believe me, do you think financial and commodity market participants are also “lying,” and hence intentionally losing lots of money. Here’s Kevin Donoghue, responding to Noah:

If the Neo-Fisherites are right, then not only is the Fed massively confused about what it’s doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts. The NFs are committed to RatEx, so if the private sector is reacting in the wrong way their theory has a serious problem.

So how come all these brilliant neo-Fisherite economists are making an elementary mistake? It’s partly because the mainstream never really internalized Milton Friedman’s insight:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. . . . After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

At first glance that looks almost neo-Fisherite. But of course Friedman had quite conventional views on the liquidity and Fisher effects. Still it makes sense that if Friedman’s insights were mostly ignored, later economists who discovered the strong correlation between low rates and low inflation might easily draw the wrong conclusion. Friedman believed that a tight money policy would initially raise rates, but over time would lower both interest rates and inflation. So over the vast majority of time you’d see inflation move in roughly the same direction as the short term interest rate directly controlled by the central bank. That’s the Fisher effect—conventional macroeconomics. But because it was not internalized (remember how crazy everyone viewed me in 2009 when I said money was tight?), it pushed the door wide open for the neo-Fisherites and MMTers, and lots of other odd critters to walk into the house.

And now we can see the subtle error that Noah Smith made in the passage quoted at the beginning of the post:

This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Reasoning from a price change!!! If I had a crystal ball, and peered into that ball, and saw that Yellen was going to hold short term rates at zero for the next 10 years, I’d absolutely predict ultra-low inflation, condition on that interest rate forecast. So no, the monetarist prediction is not that inflation will trend upward. As Milton Friedman said, the monetarist prediction is that inflation would trend downward.

Noah Smith is thinking like a Keynesian. He’s trying to translate monetarist ideas about monetary policy into a Keynesian (interest rate) language. He knows that we think easy money is associated with higher inflation, so he assumes we must also think that an extended period of low interest rates is associated with higher inflation. Not so. We don’t think low rates imply easy money.

Noah Smith and the neo-Fisherites are confusing the situation described by Friedman, with a subtly different case. Suppose a madman is put in change of the Fed who is committed to zero rates over the next 10 years, come hell or high water. Then I might forecast an upward drift in inflation; indeed I think hyperinflation would be quite possible. It depends on what else the madman did. But if you simply told me that rates would be low over the next 10 years under Janet Yellen, I’d assume that inflation would be low, and that low inflation is precisely the reason why Yellen held rates down.

There are no paradoxes to be explained, and that’s why we need to keep the “market” in market monetarism. Markets tell us that all theories of monetary policy ineffectiveness at the zero bound, and also all reverse causation theories, are wrong. (I.e. RBC, MMT, Neo-Fisherite, old Keynesian, etc., are all wrong.) It doesn’t matter if your model predicts that a change on monetary policy should have X effect on the price level. If commodity markets respond in the “wrong way” then you’ve lost. Game over. Case closed.

PS. Edward Lambert comments:

Noah,

You sense the same thing that I do. I commented on Williamson’s post pretty much your thoughts. I am in agreement with the Fisher effect.

I simply want to thank you for having sufficient wisdom and constitution to write this post.

Yikes, if Noah has a friend in Edward Lambert then he doesn’t need any more enemies.

HT. Tom Brown, TravisV.

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This entry was posted on April 26th, 2014 and is filed under Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



