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The Neo-Wicksellians vs The Neo-Fisherites

02 Nov 2020

It has been a decade since Minneapolis Federal Reserve President Narayana Kocherlakota fired the opening salvo for the neo-Fisherites with his Michigan speech. In this speech, he controversially argued that keeping interest rates low for a long period of time would lead to deflation in the long run. In doing so, he turned the entire premise of modern monetary policy on its head. And though he has since retracted this view, this kickstarted countless back-and-forth blog posts and papers in its aftermath - so what has happened to this neo-Fisherite view since then? And how does it interact with the neo-Wicksellian consensus, most prominently argued for by Michael Woodford?

The Fisher Equation

The basic premise of neo-Fisherism is that it takes the equilibrium identity of the Fisher equation $i = r + \pi$, which says that the nominal interest rate equal to the real interest rate and anticipated inflation. It notes that the real interest rate is only affected by monetary policy in the short run - the neutrality of money in the long run means that real interest rate will return to the equilibrium real interest rate as determined by the marginal return on capital. What this means is that a lowering of the nominal interest rate will lead to lower inflation or deflation in the long run, contrary to conventional intuitions around “easy money” stimulating output and inflation. Jesus Fernandez-Villaverde notes that this is distinct from a transitory monetary shock, where a temporarily lower nominal rate would increase inflation in the short run within a New Keynesian model - rather, it is about the long-run consequence of changing the nominal rate target altogether.

It seems plausible that the long-run equilibrium which is consistent with low nominal interest rates is indeed a situation with lower inflation or even deflation, dependent upon the real interest rate. Indeed, theoretical models can be constructed which produce such an outcome. This was initially backed up by a 4 part series from John Cochrane, which culminated in a paper and blog post explaining how neo-Fisherite results could be produced from New Keynesian models. Since then, we have seen various New Keynesian models producing these outcome, with papers from Stephanie Schmitt-Grohe and Martin Uribe and a behavioural NK model from Xavier Gabaix.

Coupled with David Andolfatto noting that there are models outside the New Keynesian tradition which produce the sort of outcomes desired, the data regarding Japan, the USA and Canada points us in different directions. So there is very much a plausible case for the neo-Fisherite equilibrium.

Disequilibrium Dynamics

However, there is a big difference between this being a possible equilibrium outcome and being certain of the fact that disequilibrium dynamics will bring us to said equilibrium. The likes of Brad DeLong, Andy Harless, u/wumbotarian and others have all noted the lack of a clear causal mechanism by which the equilibrium is reached. Yichuan Wang and Scott Sumner cut through the neo-Fisherite logic that when people hold more money, this will result in inflation falling to make sure people hold onto the money. It seems far more likely people will spend the money via the hot potato effect - otherwise, we might expect Zimbabwe to have faced hyperdeflation as they printed more money.

Once we recognise the importance of looking at the adjustment process, Rajiv Sethi reminds us of a 1992 paper by Peter Hewitt, which suggests that we will get an unstable instead of equilibrium outcome if we keep nominal interest rates low. This builds upon the insight by Milton Friedman and the cumulative process of Knut Wicksell before him that it is not possible for interest rates to be permanently pegged.

That is, although a neo-Fisherite equilibrium is a rational expectations equilibrium, it will not occur unless there are rational expectations ab ovo - indeed, this is exactly what Mariana Garcia-Schmidt and Michael Woodford cautioned. Although it was a relief to some that Woodford himself had confirmed the possibility, it matters that the results were dependent upon perfect foresight, Without this perfect foresight equilibrium where the revision of iterative beliefs converged to the limit, these results would not occur. And as Nick Rowe explains, the process of tatonnement by which agents within the model solve for the equilibrium is likely not a stable one - as such, we get the explosive old-Keynesian paths Noah Smith describes. In fact, Tony Yates observes that this has been thoroughly discussed in the literature, where instability and indeterminacy can occur.

Even neo-Fisherite sympathisers recognise that in their justifications, there is an alternative to the neo-Fisherite equilibrium of the central bank being unable to hold the nominal interest rate forever. And because of this instability, Nick Rowe argues that the Fisher relation is never arrived at due to never reaching the long-run equilibrium. This instability is corroborated by David Beckworth, who looks at historical cases to see the lessons it teaches us on pegging interest rates - the lesson being that there is usually a monetary and a non-monetary equilibrium in monetary models, and we may well end at the non-monetary one where money isn’t worth anything.

Reasoning from Price Changes

A broader critique of neo-Fisherism comes from Scott Sumner, who reminds us of his usual line not to reason from price changes - after all, it is possible to find mechanisms by which higher interest rates can lean towards producing higher inflation in specific circumstances. And the consequence of interest rates being the price of credit is that since Milton Friedman, we have known that we should not take interest rates as a signifier of the monetary stance and whether policy is easy or tight. This is because it depends upon the state of inflation expectations.

So a better and broader conception of monetary policy might view it as a function of price level and inflation. One-off increases in the money supply are going to make short-run interest rates fall due to the liquidity effect, without seriously affecting long-run inflation or interest rates. This is what people usually think of when they talk about expansionary monetary policy and easy money. But permanently increasing the growth rate of the money supply will lead to an increase in long-run interest rates, via the inflationary effects of easy money.

In this way, we can see several things, most of which has been known for a while. Firstly, the Fisher equation is an identity that does indeed hold in the long-run equilibrium. Secondly, disequilibrium dynamics matter - and so we can’t just reason from equilibria. The instability of an interest rate peg undermines the possibility of the neo-Fisherite outcome. Thirdly, we shouldn’t reason from price changes - what matters is the stance of monetary policy, not the neo-Wicksellian and neo-Fisherite disagreements on interest rates.

[ economics  takes  ]