Neo-Fisherism: Raising interest rates to raise inflation

The usual bit on monetary is raise rates if inflation is rising and lower them when inflation is falling. This is called as Fisherism based on Irving Fisher.

How about turning the idea on its head? How about raising rates to push higher inflation? This is called Neo-Fisherism  (trust economists to come with bad names).

Steven Williamson takes us through this radical idea:

Many macroeconomists have interpreted the Fisher relation observed in Figure 1 as involving causation running from inflation to the nominal interest rate (the usual market quote for the interest rate, not adjusted for inflation). Market interest rates are determined by the behavior of borrowers and lenders in credit markets, and these borrowers and lenders care about real rates of interest. For example, if I take out a car loan for one year at an interest rate of 10 percent, and I expect the inflation rate to be 2 percent over the next year, then I expect the real rate of interest that I will face on the car loan will be 10 percent – 2 percent = 8 percent. Since borrowers and lenders care about real rates of interest, we should expect that as inflation rises, nominal interest rates will rise as well. So, for example, if the typical market interest rate on car loans is 10 percent if the inflation rate is expected to be 2 percent, then we might expect that the market interest rate on car loans would be 12 percent if the inflation rate were expected to be 4 percent. If we apply this idea to all market interest rates, we should anticipate that, generally, higher inflation will cause nominal market interest rates to rise.

But, what if we turn this idea on its head, and we think of the causation running from the nominal interest rate targeted by the central bank to inflation? This, basically, is what Neo-Fisherism is all about. Neo-Fisherism says, consistent with what we see in Figure 1, that if the central bank wants inflation to go up, it should increase its nominal interest rate target, rather than decrease it, as conventional central banking wisdom would dictate. If the central bank wants inflation to go down, then it should decrease the nominal interest rate target.

How will this work?

To simplify, think of a world in which there is perfect certainty and where everyone knows what future inflation will be. Then, the nominal interest rate R can be expressed as

R = r + π,

where r is the real (inflation-adjusted) rate of interest and π is future inflation. Then, suppose that the central bank increases the nominal interest rate R by raising its nominal interest rate target by 1 percent and uses its tools (intervention in financial markets) to sustain this forever. What happens? Typically, we think of central bank policy as affecting real economic activity—employment, unemployment, gross domestic product, for example—through its effects on the real interest rate r. But, as is widely accepted by macroeconomists, these effects dissipate in the long run. So, after a long period of time, the increase in the nominal interest rate will have no effect on r and will be reflected only in a one-for-one increase in the inflation rate, π. In other words, in the long run, the only effect of the nominal interest rate on inflation comes through the Fisher effect; so, if the nominal interest rate went up by 1 percent, so should the inflation rate—in the long run.

But, in the short run, it is widely accepted by macroeconomists (though there is some disagreement about the exact mechanism) that an increase in R will also increase r, which will have a negative effect on aggregate economic activity—unemployment will go up and gross domestic product will go down. This is what macroeconomists call a non-neutrality of money. But note that, if an increase in R results in an increase in r, the short-run response of inflation to the increase in R must be less than one-for-one.

However, if inflation is to go down when R goes up, the real interest rate r must increase more than one-for-one with an increase in R, that is, the non-neutrality of money in the short run must be very large.

To assess these issues thoroughly, we need a well-specified macroeconomic model. But essentially all mainstream macroeconomic models predict a response of the economy to an increase in the nominal interest rate as depicted in Figure 2. In this figure, time is on the horizontal axis, and the central bank acts to increase the nominal interest rate permanently, and in an unanticipated fashion, at time T. This results in an increase in the real interest rate r on impact. Inflation π increases gradually over time, and the real interest rate falls, with the inflation rate increasing by the same amount as the increase in R in the long run. This type of response holds even in mainstream New Keynesian models, which, it is widely believed, predict that a central bank wanting to increase inflation should lower its nominal interest rate target. However, as economist John Cochrane shows, the New Keynesian model implies that if the central bank carries out the policy we have described—a permanent increase of 1 percent in the central bank’s nominal interest rate target—then the inflation rate will increase, even in the short run.

Macro is all over the place. There are just so many ideas and all of them confusing.

The author goes on to discuss how central banks are trapped in Taylor rule. The inflation has become even lower despite rates moving lower and now even in negative. If lower rates were indeed the way Japan would have been out of the trap by now.

Not sure at all. Perhaps something worth trying as how much more worse can it actually get? If inflation rises fine if not it could move a little more low.

There is a reason people have stopped taking economists seriously. Clueless and confused macro is the main reason for these beliefs..

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