This post is a note sheet I made out of the latest post from Scott Sumner in which he visits points in NeoFisherism to be sure I understand the post (and the point).
In the short run, nominal interest rates can be reduced with a tight money policy.
My impression was that tight-er policy produced a higher nominal rate in the very short run, then a drop in the longer part of the short run. I remember seeing a chart from 2008 illustrating this point, but the recollection is a bit fuzzy. Perhaps I am just splitting hairs here, but I imagined that the expansive reverse repo was the vehicle by which the Fed has been maintaining the higher short term nominal rates in the medium term with tight policy, with the reverse repo acting as a somewhat controllable monetary black hole to keep the FF rate more or less in place. It probably is not a sustainable way to regulate higher short term nominal rates because the natural rate will eventually fall farther than what can be controlled in this way.
So I think I understand this point and can move on to the next.
In the short run, nominal interest rates are usually reduced with an easy money policy.
I don’t understand this point, unless it works in the opposite direction of how I understand point #1. However, this point seems to be referring that up to 2008, this was the way reductions in the short nominal rates were accomplished in the short run. The longer run of a similar policy would be for rates to rise.
Because money is neutral in the long run, any monetary policy that permanently reduces nominal interest rates must be disinflationary.
I understand this without further comment, but I would point out that it’s consistent with my understanding of point #1.
A tight money policy reduces the natural rate of interest.
So far so good. I am with the program on this one. Now for the challenging part…
So why are so many mainstream economists horrified by NeoFisherism? I think the sticking point is #2.
Yes. #2 is hard to understand – for more than mainstream economists. Though my opinion is that points 1, 3 and 4 are the horrifying ones (tight money strictly for the purpose of manipulating interest rates is horrifying).
This next point has me a little tweeked:
The vast majority of the time, a reduction in interest rates on any given day represents an easier monetary policy than a counterfactual policy where the central bank doesn’t reduce interest rates. Not always (in which case #1 and #3 would no longer be true), but the vast majority of the time. But the NeoFisherian thought experiment requires that the lower rates be achieved via tighter monetary policy.
So a daily reduction in the nominal short rate represents an easier policy than if the bank doesn’t reduce rates. This seems so simple – of course if the bank says the rate is X and the daily rate is lower, to someone who believes that lower rates equals easy money, yes. But there is no reliable way to tell whether the lower rate is caused by easy or tight policy, and the parenthetical is only relevant if an easy policy caused the reduction in rates because points 1 and 3 are about tight money.
I think that people are confused about what NeoFisherians are talking about when they discuss policy option number three. In the minds of most economists, switching to a permanently lower interest rate seems like an expansionary monetary policy, because on any given day cutting interest rates usually is an expansionary monetary policy.
I am not an economist, mainstream or otherwise. I don’t agree that low rates are expansionary in and of themselves; NeoFiserites horrify me because they take interest rates to an undeserved level of obsession
If you don’t want the price level to blow up, then any permanent switch to a lower interest rate must be done with a tighter monetary policy. If the central bank tried to do it with an easier money policy then they’d have to inject larger and larger amounts of liquidity, eventually causing hyperinflation and then complete collapse of the system. So any sustainable policy of low interest rates must be contractionary.
I am with this point until the last sentence because it assumes a level of long term control over contractionary policy that I don’t believe exists. Sustainable isn’t the correct word, even at face value, because even when in control, the condition is not politically viable in the long run – Japan the is case in point. It remains to be seen whether the US will become kin. It goes without saying that loss of control of contractionary policy would result in the price level imploding, hyperdeflation, and collapse the system, and nether extreme represents good policy. How about we allow interest rates to take care of themselves for a nice, rational change of pace?
A contractionary monetary policy lowers the natural rate of interest. I think many economists picture a world where the natural rate of interest is not affected by monetary policy. In that world, lowering the policy rate makes policy more expansionary, because the stance of monetary policy is the gap between the policy rate and the natural rate (assumed to be stable). In fact, any sustainable policy of low rates must be caused by tight money, and any tight money policy will reduce the natural rate of interest so much that monetary policy does not get easier, despite the lower fed funds target. This is Japan since 1995.
I am with this point %100.
So far I’ve presented a picture that is somewhat sympathetic to the NeoFisherians. Let me conclude with a discussion of what I don’t like about the way NeoFisherians present their theory.
The listener is led to believe that if you want lower inflation, you need to cut interest rates. I’d say if you want lower inflation you need to cut interest rates via a tight money policy. Any attempt to achieve lower inflation via a cut in interest rates achieved through an easier money policy will end in disaster.
Yep. I disagree with the notion that if you want lower inflation you need to cut rates (even though cutting rates would ultimately occur). But in correcting this mistake that is the result of intellectual shortcutting, I would say that if you want lower inflation, you need to slow or cut growth in NGDP because interest rates are not causes in and of themselves; and any attempt to judge and adjust the stance of policy solely via interest rates will end in disaster of one sort or another.
Because the vast majority of rate cuts represent easier money than the counterfactual of not cutting rates on that given day, it is not accurate to imply that the first step to lowering inflation is for the central bank to do the sort of rate cut that it often does do–i.e., liquidity injections. Instead, the NeoFisherians should argue that the first step to lower inflation is for central banks to do the sort of rate cut that the Swiss National Bank did in January 2015, when they simultaneously appreciated their currency and created a credible policy of further currency appreciation going forward. That credible promise led to lower nominal interest rates via the interest parity condition, and lower inflation expectations via the currency appreciation (combined with PPP.)
This point needs some wordsmithing because interest rates reflect changes in the stance of policy rather than cause a change in the stance of policy, and movements in rates are difficult to interpret in their own context. The first step to lowering inflation is to announce the intention, and the rest of what is done, like selling assets and encouraging hoarding is mechanical stuff that happens to enforce the point – first you say it, then you get it.
Has anyone commented on the similarity between the NeoFisherian puzzle identified in points #1 – #4 above, and the puzzle that led to the Dornbusch overshooting model? The overshooting model was an attempt to resolved the following puzzle in a conventional Keynesian fashion:
Puzzle: Easy money seems to lead to both actual currency depreciation and expected currency appreciation.
Rudi Dornbusch wanted to show how easier money could lead to expected currency appreciation (which is an implication of lower nominal interest rates combined with the interest parity condition.) His solution was overshooting.
An example of the puzzle might be the pound sterling post-Brexit in which the BoE did not react until very recently. Natural loosening of policy, or easy by omission. It would be interesting to take a deep dive on market short rates over the last six months to see what happened. But I think might contain some of what is sought.