Archive for the 'inflation' Category

Jason Furman Hyperventilates about Wages and Inflation

Published March 20, 2023 inflation , Jason , Jason Furman , transitory inflation 2 Comments
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Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.

Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.

The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.

The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.

Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.

Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.

I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.

But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.

But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.

That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.

What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.

What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.

The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.

Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.

The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.

Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.

If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.

After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.

Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.

Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.

Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.

[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.

This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.

What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.

Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.

To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.

Other, related, confusions emerge in Furman’s next paragraph.

Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.

In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.

It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.

Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.

Furman makes another astonishing claim in the next paragraph.

Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.

How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.

Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.

So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.

Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.

Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.

With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.

For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.

In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.

Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.

Why I’m not Apologizing for Calling Recent Inflation Transitory

Published April 19, 2022 inflation , Larry Summers , Uncategorized 9 Comments
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I’ve written three recent blogposts explaining why the inflation that began accelerating in the second half of 2021 was likely to be transitory (High Inflation Anxiety, Sic Transit Inflatio del Mundi, and Wherein I Try to Calm Professor Blanchard’s Nerves). I didn’t deny that inflation was accelerating and likely required a policy adjustment, but I also didn’t accept that the inflation threat was (or is) as urgent as some, notably Larry Summers, were suggesting.

In my two posts in late 2021, I argued that Summers’s concerns were overblown, because the burst of inflation in the second half of 2021 was caused mainly by increased consumer spending as consumers began drawing down cash and liquid assets accumulated when spending outlets had been unavailable, and was exacerbated by supply bottlenecks that kept output from accommodating increased consumer demand. Beyond that, despite rising expectations at the short-end, I minimized concerns about the unanchoring of inflation expectations owing to the inflationary burst in the second half of 2021, in the absence of any signs of rising inflation expectations in longer-term (5 years or more) bond prices.

Aside from criticizing excessive concern with what I viewed as a transitory burst of inflation not entirely caused by expansive monetary policy, I cautioned against reacting to inflation caused by negative supply shocks. In contrast to Summers’s warnings about the lessons of the 1970s when high inflation became entrenched before finally being broken — at the cost of the worst recession since the Great Depression, by Volcker’s anti-inflation policy — I explained that much of 1970s inflation was caused by supply-side oil shocks, which triggered an unnecessarily severe monetary tightening in 1974-75 and a deep recession that only modestly reduced inflation. Most of the decline in inflation following the oil shock occurred during the 1976 expansion when inflation fell to 5%. But, rather than allow a strong recovery to proceed on its own, the incoming Carter Administration and a compliant Fed, attempting to accelerate the restoration of full employment, increased monetary expansion. (It’s noteworthy that much of the high unemployment at the time reflected the entry of baby-boomers and women into the labor force, one of the few occasions in which an increased natural rate of unemployment can be easily identified.)

The 1977-79 monetary expansion caused inflation to accelerate to the high single digits even before the oil-shocks of 1979-80 led to double-digit inflation, setting the stage for Volcker’s brutal disinflationary campaign in 1981-82. But the mistake of tightening of monetary policy to suppress inflation resulting from negative supply shocks (usually associated with rising oil prices) went unacknowledged, the only lesson being learned, albeit mistakenly, was that high inflation can be reduced only by a monetary tightening sufficient to cause a deep recession.

Because of that mistaken lesson, the Fed, focused solely on the danger of unanchored inflation expectations, resisted pleas in the summer of 2008 to ease monetary policy as the economy was contracting and unemployment rising rapidly until October, a month after the start of the financial crisis. That disastrous misjudgment made me doubt that the arguments of Larry Summers et al. that tight money is required to counter inflation and prevent the unanchoring of inflation expectations, recent inflation being largely attributable, like the inflation blip in 2008, to negative supply shocks, with little evidence that inflation expectations had, or were likely to, become unanchored.

My first two responses to inflation hawks occurred before release of the fourth quarter 2021 GDP report. In the first three quarters, nominal GDP grew by 10.9%, 13.4% and 8.4%. My hope was that the Q4 rate of increase in nominal GDP would show a further decline from the Q3 rate, or at least show no increase. The rising trend of inflation in the final months of 2021, with no evidence of a slowdown in economic activity, made it unlikely that nominal GDP growth in Q4 had not accelerated. In the event, the acceleration of nominal GDP growth to 14.5% in Q4 showed that a tightening of monetary policy had become necessary.

Although a tightening of policy was clearly required to reduce the rate of nominal GDP growth, there was still reason for optimism that the negative supply-side shocks that had amplified inflationary pressure would recede, thereby allowing nominal GDP growth to slow down with no contraction in output and employment. Unfortunately, the economic environment deteriorated drastically in the latter part of 2021 as Russia began the buildup to its invasion of Ukraine, and deteriorated even more once the invasion started.

The price of Brent crude, just over $50/barrel in January 2021, rose to over $80/barrel in November of 2021. Tensions between Russia and Ukraine rose steadily during 2021, so it is not easy to determine the extent to which those increasing tensions were causing oil prices to rise and to what extent they rose because of increasing economic activity and inflationary pressure on oil prices. Brent crude fell to $70 in December before rising to $100/barrel in February on the eve of the invasion, briefly reaching $130/barrel shortly thereafter, before falling back to $100/barrel. Aside from the effect on energy prices, generalized uncertainty and potential effects on wheat prices and the federal budget from a drawn-out conflict in Ukraine have caused inflation expectations to increase.

Under these circumstances, it makes little sense to tighten policy suddenly. The appropriate policy strategy is to lean toward restraint and announce that the aim of policy is to reduce the rate of GDP growth gradually until a sustainable 4-5% rate of nominal GDP growth consistent with an inflation rate of about 2-3% a year is reached. The overnight rate of interest being the primary instrument whereby the Fed can either increase or decrease the rate of nominal GDP growth, it is unnecessary, and probably unwise, for the Fed to announce in advance a path of interest-rate increases. Instead, the Fed should communicate its target range for nominal GDP growth and condition the size and frequency of future rate increases on the deviations of the economy from that targeted growth path of nominal GDP.

Previous monetary policy mistakes that caused either recessions or excessive inflation have for more than half a century resulted from using interest rates or some other policy instrument to control inflation or unemployment rather than to moderate deviations from a stable growth rate in nominal GDP. Attempts to reduce inflation by maintaining or increasing already high interest rates until inflation actually fell needlessly and perversely prolonged and deepened recessions. Monetary conditions ought be eased as soon as nominal GDP growth falls below the target range for nominal GDP growth. Inflation automatically tends to fall in the early stages of recovery from a recession, and nothing is gained, and much harm is done, by maintaining a tight-money policy after nominal GDP growth has fallen below the target range. That’s the great, and still unlearned, lesson of monetary policy.

Krugman and Sumner on the Zero-Interest Lower Bound: Some History of Thought

Published July 8, 2021 A. C. Pigou , Alfred Marshall , Earl Thompson , expected inflation , inflation , Keynes , Paul Krugman , Scott Sumner , Uncategorized 24 Comments
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UPDATE: Re-upping my post from July 8, 2011

I indicated in my first posting on Tuesday that I was going to comment on some recent comparisons between the current anemic recovery and earlier more robust recoveries since World War II. The comparison that I want to perform involves some simple econometrics, and it is taking longer than anticipated to iron out the little kinks that I keep finding. So I will have to put off that discussion a while longer. As a diversion, I will follow up on a point that Scott Sumner made in discussing Paul Krugman’s reasoning for having favored fiscal policy over monetary policy to lead us out of the recession.

Scott’s focus is on the factual question whether it is really true, as Krugman and Michael Woodford have claimed, that a monetary authority, like, say, the Bank of Japan, may simply be unable to create the inflation expectations necessary to achieve equilibrium, given the zero-interest-rate lower bound, when the equilibrium real interest rate is less than zero. Scott counters that a more plausible explanation for the inability of the Bank of Japan to escape from a liquidity trap is that its aversion to inflation is so well-known that it becomes rational for the public to expect that the Bank of Japan would not permit the inflation necessary for equilibrium.

It seems that a lot of people have trouble understanding the idea that there can be conditions in which inflation — or, to be more precise, expected inflation — is necessary for a recovery from a depression. We have become so used to thinking of inflation as a costly and disruptive aspect of economic life, that the notion that inflation may be an integral element of an economic equilibrium goes very deeply against the grain of our intuition.

The theoretical background of this point actually goes back to A. C. Pigou (another famous Cambridge economist, Alfred Marshall’s successor) who, in his 1936 review of Keynes’s General Theory, referred to what he called Mr. Keynes’s vision of the day of judgment, namely, a situation in which, because of depressed entrepreneurial profit expectations or a high propensity to save, macro-equilibrium (the equality of savings and investment) would correspond to a level of income and output below the level consistent with full employment.

The “classical” or “orthodox” remedy to such a situation was to reduce the rate of interest, or, as the British say “Bank Rate” (as in “Magna Carta” with no definite article) at which the Bank of England lends to its customers (mainly banks).  But if entrepreneurs are so pessimistic, or households so determined to save rather than consume, an equilibrium corresponding to a level of income and output consistent with full employment could, in Keynes’s ghastly vision, only come about with a negative interest rate. Now a zero interest rate in economics is a little bit like the speed of light in physics; all kinds of crazy things start to happen if you posit a negative interest rate and it seems inconsistent with the assumptions of rational behavior to assume that people would lend for a negative interest when they could simply hold the money already in their pockets. That’s why Pigou’s metaphor was so powerful. There are layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes, but I won’t pursue that tangent here, tempting though it would be to go in that direction.

The conclusion that Keynes drew from his model is the one that we all were taught in our first course in macro and that Paul Krugman holds close to his heart, the government can come to the rescue by increasing its spending on whatever, thereby increasing aggregate demand, raising income and output up to the level consistent with full employment. But Pigou, whose own policy recommendations were not much different from those of Keynes, felt that Keynes had left out an important element of the model in his discussion. As a matter of logic, which to Pigou was as, or more important than, policy, an economy confronting Keynes’s day of judgment would not forever be stuck in “underemployment equilibrium” just because the rate of interest could not fall to the (negative) level required for full employment.

Rather, Pigou insisted, at least in theory, though not necessarily in practice, deflation, resulting from unemployed workers bidding down wages to gain employment, would raise the real value of the money supply (fixed in nominal terms in Keynes’s model) thereby generating a windfall to holders of money, inducing them to increase consumption, raising aggregate demand and eventually restoring full employment.  Discussion of the theoretical validity and policy relevance of what came to be known as the Pigou effect (or, occasionally, as the Pigou-Haberler Effect, or even the Pigou-Haberler-Scitovsky effect) became a really big deal in macroeconomics in the 1940s and 1950s and was still being taught in the 1960s and 1970s.

What seems remarkable to me now about that whole episode is that the analysis simply left out the possibility that the zero-interest-rate lower bound becomes irrelevant if the expected rate of inflation exceeds the putative negative equilibrium real interest rate that would hypothetically generate a macro-equilibrium at a level of income and output consistent with full employment.

If only Pigou had corrected the logic of Keynes’s model by positing an expected rate of inflation greater than the negative real interest rate rather than positing a process of deflation to increase the real value of the money stock, how different would the course of history and the development of macroeconomics and monetary theory have been.

One economist who did think about the expected rate of inflation as an equilibrating variable in a macroeconomic model was one of my teachers, the late, great Earl Thompson, who introduced the idea of an equilibrium rate of inflation in his remarkable unpublished paper, “A Reformulation of Macreconomic Theory.” If inflation is an equilibrating variable, then it cannot make sense for monetary authorities to commit themselves to a single unvarying target for the rate of inflation. Under certain circumstances, macroeconomic equilibrium may be incompatible with a rate of inflation below some minimum level. Has it occurred to the inflation hawks on the FOMC and their supporters that the minimum rate of inflation consistent with equilibrium is above the 2 percent rate that Fed has now set as its policy goal?

One final point, which I am still trying to work out more coherently, is that it really may not be appropriate to think of the real rate of interest and the expected rate of inflation as being determined independently of each other. They clearly interact. As I point out in my paper “The Fisher Effect Under Deflationary Expectations,” increasing the expected rate of inflation when the real rate of interest is very low or negative tends to increase not just the nominal rate, but the real rate as well, by generating the positive feedback effects on income and employment that result when a depressed economy starts to expand.

My Paper “The Fisher Effect and the Financial Crisis of 2008” Is Now Available

Published September 12, 2018 expectations , financial crisis , Fisher effect , inflation 3 Comments
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Back in 2009 or 2010, I became intrigued by what seemed to me to be a consistent correlation between the tendency of the stock market to rise on news of monetary easing and potentially inflationary news. I suspected that there might be such a correlation because of my work on the Great Depression inspired by Earl Thompson, from whom I first learned about a monetary theory of the Great Depression very different from Friedman’s monetary theory expounded in his Monetary History of the United States. Thompson’s theory focused on disturbances in the gold market associated with the demonetization of gold during World War I and the attempt to restore the gold standard in the 1920s, which, by increasing the world demand for gold, was the direct cause of the deflation that led to the Great Depression.

I later came to discover that Ralph Hawtrey had already propounded Thompson’s theory in the 1920s almost a decade before the Great Depression started, and my friend and fellow student of Thompson, Ron Batchelder made a similar discovery about Gustave Cassel. Our shared recognition that Thompson’s seemingly original theory of the Great Depression had been anticipated by Hawtrey and Cassel led us to collaborate on our paper about Hawtrey and Cassel. As I began to see parallels between the financial fragility of the 1920s and the financial fragility that followed the housing bubble, I began to suspect that deflationary tendencies were also critical to the financial crisis of 2008.

So I began following daily fluctuations in the principal market estimate of expected inflation: the breakeven TIPS spread. I pretty quickly became persuaded that the correlation was powerful and meaningful, and I then collected data about TIPS spreads from 2003, when the Treasury began offering TIPS securities, to see if the correlation between expected inflation and asset prices had been present 2003 or was a more recent phenomenon.

My hunch was that the correlation would not be observed under normal macroeconomic conditions, because it is only when the expected yield from holding money approaches or exceeds the yield from holding real assets that an increase in expected inflation, by reducing the expected yield from holding money, would induce people to switch from holding money to holding assets, thereby driving up the value of assets.

And that’s what the data showed; the correlation between expected inflation and asset prices only emerged after in 2008 in the period after a recession started at the end of 2007, even before the start of the financial crisis exactly 10 years in September 2008. When I wrote up the paper and posted it (“The Fisher Effect Under Deflationary Expectations“), Scott Sumner, who had encouraged me to write up the results after I told him about my results, wrote a blogpost about the paper. Paul Krugman picked up on Scott’s post and wrote about it on his blog, generating a lot of interest in the paper.

Although I was confident that the data showed a strong correlation between inflation and stock prices after 2008, I was less confident that I had done the econometrics right, so I didn’t try to publish the original 2011 version of the paper. With Scott’s encouragement, I have continued to collected more data as time passed, confirming that the correlation remained even after the start of a recovery while short-term interest rates remained at or near the zero lower bound. The Mercatus Center whose Program on Monetary Policy is directed by Scott has just released the new version of the paper as a Working Paper. The paper can also be downloaded from SSRN.

Aside from longer time span covered, the new version of the paper has refined and extended the theoretical account for when and why a correlation between expected inflation and asset prices is likely be observed and when and why it is unlikely to be observed. I have also done some additional econometric testing beyond the basic ordinary least square (OLS) regression estimates originally presented, and explained why I think it is unlikely that more sophisticated econometric techniques such as an error-correction model would generate more reliable results than those generated by simple OLS regrissions. Perhaps in further work, I will attempt to actually construct an explicit error-correction model and compare the results using OLS and an error-correction model.

Here is the abstract of the new version of the paper.

This paper uses the Fisher equation relating the nominal interest rate to the real interest rate and
expected inflation to provide a deeper explanation of the financial crisis of 2008 and the subsequent recovery than attributing it to the bursting of the housing-price bubble. The paper interprets the Fisher equation as an equilibrium condition in which expected returns from holding real assets and cash are equalized. When inflation expectations decline, the return to holding cash rises relative to holding real assets. If nominal interest rates are above the zero lower bound, equilibrium is easily restored by adjustments in nominal interest rates and asset prices. But at the zero lower bound, nominal interest rates cannot fall, forcing the entire adjustment onto falling asset prices, thereby raising the expected real return from holding assets. Such an adjustment seems to have triggered the financial crisis of 2008, when the Federal Reserve delayed reducing nominal interest rates out of a misplaced fear of inflation in the summer of 2008 when the economy was already contracting rapidly. Using stock market price data and inflation-adjusted US Treasury securities data, the paper finds that, unlike the 2003–2007 period, when stock prices were uncorrelated with expected inflation, from 2008 through at least 2016, stock prices have been consistently and positively correlated with expected inflation.

The Pot Calls the Kettle Black

Published July 17, 2015 Federal Reserve , inflation , Ludwig von Mises , Money Illusion , Say's Law , Uncategorized 7 Comments
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I had not planned to post anything today, but after coming across an article (“What the Fed Really Wants Is to Reduce Real Wages”) by Alex Pollock of AEI on Real Clear Markets this morning, I decided that I could not pass up this opportunity to expose a) a basic, but common and well-entrenched, error in macroeconomic reasoning, and b) the disturbingly hypocritical and deceptive argument in the service of which the faulty reasoning was deployed.

I start by quoting from Pollock’s article.

To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.

The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don’t fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don’t like to have nominal wages fall– they are “sticky.” People are subject to Money Illusion and they don’t think in inflation-adjusted terms. Therefore create inflation to make real wages fall.

In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of “long-term inflation goals.” Promoting the cause of what ultimately became the Fed’s goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. “To my mind,” she said, “the most important argument for some low inflation rate is…that a little inflation lowers unemployment by facilitating adjustments in relative pay”-in other words, by lowering real wages. This reflects “a world where individuals deeply dislike nominal pay cuts,” she continued. “I think we are dealing here with a very deep-rooted property of the human psyche”-that is, Money Illusion.

In sum, since “workers resist and firms are unwilling to impose nominal pay cuts,” the Fed has to be able to reduce real wages instead by inflation.

But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?

This summary of why some low rate of inflation may promote labor-0market flexibility is not far from the truth, but it does require some disambiguation. The first distinction to make is that while Janet Yellen was talking about adjustments in relative pay, presumably adjustments in wages both across different occupations and also across different geographic areas — a necessity even if the overall level of real wages is stable — Pollock simply talks about reducing real wages in general.

But there is a second, more subtle distinction to make here as well, and that distinction makes a big difference in how we understand what the Fed is trying to do. Suppose a reduction in real wages in general, or in the relative wages of some workers is necessary for labor-market equilibrium. To suggest that only reason to use inflation to reduce the need for nominal wage cuts is a belief in “Money Illusion” is deeply misleading. The concept of “Money Illusion” is only meaningful when applied to equilibrium states of the economy. Thus the absence of “Money Illusion” means that the equilibrium of the economy (under the assumption that the economy has a unique equilibrium — itself, a very questionable assumption, but let’s not get diverted from this discussion to an even messier and more complicated one) is the same regardless of how nominal prices are scaled up or down. It is entirely possible to accept that proposition (which seems to follow from fairly basic rationality assumptions) without also accepting that it is irrelevant whether real-wage reductions in response to changing circumstances are brought about by inflation or by nominal-wage cuts.

Since any discussion of changes in relative wages presumes that a transition from one equilibrium state to another equilibrium state is occurring, the absence of Money Illusion, being a property of equilibrium,  can’t tell us anything about whether the transition from one equilibrium state to another is more easily accomplished by way of nominal-wage cuts or by way of inflation. If, as a wide range of historical evidence suggests, real-wage reductions are more easily effected by way of inflation than by way of nominal-wage cuts, it is plausible to assume that minimizing nominal-wage cuts will ease the transition from the previous equilibrium to the new one.

Why is that? Here’s one way to think about it. The resistance to nominal-wage cuts implies that more workers will be unemployed initially if nominal wages are cut than if there is an inflationary strategy. It’s true that the unemployment is transitory (in some sense), but the transitory unemployment will be with reduced demand for other products, so the effect of unemployment of some workers is felt by other sectors adn other workers. This implication is not simply the multiplier effect of Keynesian economics, it is also a direct implication of the widely misunderstood Say’s Law, which says that supply creates its own demand. So if workers are more likely to become unemployed in the transition to an equilibrium with reduced real wages if the real-wage reduction is accomplished via a cut in nominal wages than if accomplished by inflation, then inflation reduces the reduction in demand associated with resistance to nominal-wage cuts. The point is simply that we have to consider not just the final destination, but also the route by which we get there. Sometimes the route to a destination may be so difficult and so dangerous, that we are better off not taking it and looking for an alternate route. Nominal wage cuts are very often a bad route by which to get to a new equilibrium.

That takes care of the error in macroeconomic reasoning, but let’s follow Pollock a bit further to get to the hypocrisy and deception.

This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for “the engineering of inflation” is: “To preserve the height of nominal wage rates…while real wage rates should rather sink.” But, he added pointedly, “neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates.” The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, “they were anxious not to mention” this. So is the current Fed.

Nonetheless, the Fed feels it can pontificate on “inequality” and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.

Actually, it is Pollock who is being disingenuous here. The Fed does not have a policy on real wages. Real wages are determined for the most part in free and competitive labor markets. In free and competitive labor markets, the equilibrium real wage is determined independently of the rate of inflation. Remember, there’s no Money Illusion. Minimizing nominal-wage cuts is not a policy aimed at altering equilibrium real wages, which are whatever market forces dictate, but of minimizing the costs associated with the adjustments in real wages in response to changing economic conditions.

I know that it’s always fun to quote Ludwig von Mises on inflation, but if you are going to quote Mises about how inflation is just a scheme designed to reduce real wages, you ought to at least be frank enough to acknowledge that what Mises was advocating was cutting nominal wages instead.

And it is worth recalling that even Mises recognized that nominal wages could not be reduced without limit to achieve equilibrium. In fact, Mises agreed with Keynes that it was a mistake for England in 1925 to restore sterling convertibility into gold at the prewar parity, because doing so required further painful deflation and nominal wage cuts. In other words, even Mises could understand that the path toward equilibrium mattered. Did that mean that Mises was guilty of believing in Money Illusion? Obviously not. And if the rate of deflation can matter to employment in the transition from one equilibrium to another, as Mises obviously conceded, why is it inconceivable that the rate of inflation might also matter?

So Pollock is trying to have his cake and eat it. He condemns the Fed for using inflation as a tool by which to reduce real wages. Actually, that is not what the Fed is doing, but, let us suppose that that’s what the Fed is doing, what alternative does Pollock have in mind? He won’t say. In other words, he’s the pot.

A New Paper on the Short, But Sweet, 1933 Recovery Confirms that Hawtrey and Cassel Got it Right

Published May 15, 2015 Anna Schwartz , Cassel , Daniel Nelson , expectations , Gisela Rua , gold standard , Great Depression , inflation , Milton Friedman 9 Comments
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In a recent post, the indispensable Marcus Nunes drew my attention to a working paper by Andrew Jalil of Occidental College and Gisela Rua of the Federal Reserve Board. The paper is called “Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record. “ Subsequently I noticed that Mark Thoma had also posted the abstract on his blog.

 Here’s the abstract:

This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event-studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence—both quantitative and narrative—that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

There’s a lot of new and interesting stuff in this paper even though the basic narrative framework goes back almost 80 years to the discussion of the 1933 recovery in Hawtrey’s Trade Depression and The Way Out. The paper highlights the importance of rising inflation (or price-level) expectations in generating the recovery, which started within a few weeks of FDR’s inauguration in March 1933. In the absence of direct measures of inflation expectations, such as breakeven TIPS spreads, that are now available, or surveys of consumer and business expectations, Jalil and Rua document the sudden and sharp shift in expectations in three different ways.

First, they show document that there was a sharp spike in news coverage of inflation in April 1933. Second, they show an expectational shift toward inflation by a close analysis of the economic reporting and commentary in the Economist and in Business Week, providing a fascinating account of the evolution of FDR’s thinking and how his economic policy was assessed in the period between the election in November 1932 and April 1933 when the gold standard was suspended. Just before the election, the Economist observed

No well-informed man in Wall Street expects the outcome of the election to make much real difference in business prospects, the argument being that while politicians may do something to bring on a trade slump, they can do nothing to change a depression into prosperity (October 29, 1932)

 On April 22, 1933, just after FDR took the US of the gold standard, the Economist commented

As usual, Wall Street has interpreted the policy of the Washington Administration with uncanny accuracy. For a week or so before President Roosevelt announced his abandonment of the gold standard, Wall Street was “talking inflation.”

 A third indication of increasing inflation is drawn from the five independent economic forecasters which all began predicting inflation — some sooner than others  — during the April-May time frame.

Jalil and Rua extend the important work of Daniel Nelson whose 1991 paper “Was the Deflation of 1929-30 Anticipated? The Monetary Regime as Viewed by the Business Press” showed that the 1929-30 downturn coincided with a sharp drop in price level expectations, providing powerful support for the Hawtrey-Cassel interpretation of the onset of the Great Depression.

Besides persuasive evidence from multiple sources that inflation expectations shifted in the spring of 1933, Jalil and Rua identify 5 key events or news shocks that focused attention on a changing policy environment that would lead to rising prices.

1 Abandonment of the Gold Standard and a Pledge by FDR to Raise Prices (April 19)

2 Passage of the Thomas Inflation Amendment to the Farm Relief Bill by the Senate (April 28)

3 Announcement of Open Market Operations (May 24)

4 Announcement that the Gold Clause Would Be Repealed and a Reduction in the New York Fed’s Rediscount Rate (May 26)

5 FDR’s Message to the World Economic Conference Calling for Restoration of the 1926 Price Level (June 19)

Jalil and Rua perform an event study and find that stock prices rose significantly and the dollar depreciated against gold and pound sterling after each of these news shocks. They also discuss the macreconomic effects of shift in inflation expectations, showing that a standard macro model cannot account for the rapid 1933 recovery. Further, they scrutinize the claim by Friedman and Schwartz in their Monetary History of the United States that, based on the lack of evidence of any substantial increase in the quantity of money, “the economic recovery in the half-year after the panic owed nothing to monetary expansion.” Friedman and Schwartz note that, given the increase in prices and the more rapid increase in output, the velocity of circulation must have increased, without mentioning the role of rising inflation expectations in reducing that amount of cash (relative to income) that people wanted to hold.

Jalil and Rua also offer a very insightful explanation for the remarkably rapid recovery in the April-July period, suggesting that the commitment to raise prices back to their 1926 levels encouraged businesses to hasten their responses to the prospect of rising prices, because prices would stop rising after they reached their target level.

The literature on price-level targeting has shown that, relative to inflation targeting, this policy choice has the advantage of removing more uncertainty in terms of the future level of prices. Under price-level targeting, inflation depends on the relationship between the current price level and its target. Inflation expectations will be higher the lower is the current price level. Thus, Roosevelt’s commitment to a price-level target caused market participants to expect inflation until prices were back at that higher set target.

A few further comments before closing. Jalil and Rua have a brief discussion of whether other factors besides increasing inflation expectations could account for the rapid recovery. The only factor that they mention as an alternative is exit from the gold standard. This discussion is somewhat puzzling inasmuch as they already noted that exit from the gold standard was one of five news shocks (and by all odds the important one) in causing the increase in inflation expectations. They go on to point out that no other country that left the gold standard during the Great Depression experienced anywhere near as rapid a recovery as did the US. Because international trade accounted for a relatively small share of the US economy, they argue that the stimulus to production by US producers of tradable goods from a depreciating dollar would not have been all that great. But that just shows that the macroeconomic significance of abandoning the gold standard was not in shifting the real exchange rate, but in raising the price level. The fact that the US recovery after leaving the gold standard was so much more powerful than it was in other countries is because, at least for a short time, the US sought to use monetary policy aggressively to raise prices, while other countries were content merely to stop the deflation that the gold standard had inflicted on them, but made no attempt to reverse the deflation that had already occurred.

Jalil and Rua conclude with a discussion of possible explanations for why the April-July recovery seemed to peter out suddenly at the end of July. They offer two possible explanations. First passage of the National Industrial Recovery Act in July was a negative supply shock, and second the rapid recovery between April and July persuaded FDR that further inflation was no longer necessary, with actual inflation and expected inflation both subsiding as a result. These are obviously not competing explanations. Indeed the NIRA may have itself been another reason why FDR no longer felt inflation was necessary, as indicated by this news story in the New York Times

The government does not contemplate entering upon inflation of the currency at present and will issue cheaper money only as a last resort to stimulate trade, according to a close adviser of the President who discussed financial policies with him this week. This official asserted today that the President was well satisfied with the business improvement and the government’s ability to borrow money at cheap rates. These are interpreted as good signs, and if the conditions continue as the recovery program broadened, it was believed no real inflation of the currency would be necessary. (“Inflation Putt Off, Officials Suggest,” New York Times, August 4, 1933)

If only . . .

Just How Infamous Was that Infamous Open Letter to Bernanke?

Published October 28, 2014 Ben Bernanke , credit deadlock , deflation , demand for money , gold standard , Great Depression , Hawtrey , inflation , Keynes , liquidity trap , Little Depression , monetary policy , QE , zero lower bound 21 Comments
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There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 

Explaining Post-Traumatic-Inflation Stress Disorder

Published September 9, 2014 gold standard , inflation , Paul Krugman , Steve Waldman 22 Comments
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Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Never Reason from a Disequilibrium

Published May 24, 2014 Axel Leijonfuvud , inflation , involuntary unemployment , Keynes , Scott Sumner 7 Comments

One of Scott Sumner’s many contributions as a blogger has been to show over and over and over again how easy it is to lapse into fallacious economic reasoning by positing a price change and then trying to draw inferences about the results of the price change. The problem is that a price change doesn’t just happen; it is the result of some other change. There being two basic categories of changes (demand and supply) that can affect price, there are always at least two possible causes for a given price change. So, until you have specified the antecedent change responsible for the price change under consideration, you can’t work out the consequences of the price change.

In this post, I want to extend Scott’s insight in a slightly different direction, and explain how every economic analysis has to begin with a statement about the initial conditions from which the analysis starts. In particular, you need to be clear about the equilibrium position corresponding to the initial conditions from which you are starting. If you posit some change in the system, but your starting point isn’t an equilibrium, you have no way of separating out the adjustment to the change that you are imposing on the system from the change the system would be undergoing simply to reach the equilibrium toward which it is already moving, or, even worse, from the change the system would be undergoing if its movement is not toward equilibrium.

Every theoretical analysis in economics properly imposes a ceteris paribus condition. Unfortunately, the ubiquitous ceteris paribus condition comes dangerously close to rendering economic theory irrefutable, except perhaps in a statistical sense, because empirical refutations of the theory can always be attributed to changes, abstracted from only in the theory, but not in the real world of our experience. An empirical model with a sufficient number of data points may be able to control for the changes in conditions that the theory holds constant, but the underlying theory is a comparison of equilibrium states (comparative statics), and it is quite a stretch to assume that the effects of perpetual disequilibrium can be treated as nothing but white noise. Austrians are right to be skeptical of econometric analysis; so was Keynes, for that matter. But skepticism need not imply nihilism.

Let me try to illustrate this principle by applying it to the Keynesian analysis of involuntary unemployment. In the General Theory Keynes argued that if adequate demand is deficient, the likely result is an equilibrium with involuntary unemployment. The “classical” argument that Keynes disputed was that, in principle at least, involuntary unemployment could not persist, because unemployed workers, if only they would accept reduced money wages, would eventually find employment. Keynes denied that involuntary unemployment could not persist, arguing that if workers did accept reduced money wages, the wage reductions would not get translated into reduced real wages. Instead, falling nominal wages would induce employers to cut prices by roughly the same percentage as the reduction in nominal wages, leaving real wages more or less unchanged, thereby nullifying the effectiveness of nominal-wage cuts, and, instead, fueling a vicious downward spiral of prices and wages.

In making this argument, Keynes didn’t dispute the neoclassical proposition that, with a given capital stock, the marginal product of labor declines as employment increases, implying that real wages have to fall for employment to be increased. His argument was about the nature of the labor-supply curve, labor supply, in Keynes’s view, being a function of both the real and the nominal wage, not, as in the neoclassical theory, only the real wage. Under Keynes’s “neoclassical” analysis, the problem with nominal-wage cuts is that they don’t do the job, because they lead to corresponding price cuts. The only way to reduce unemployment, Keynes insisted, is to raise the price level. With nominal wages constant, an increased price level would achieve the real-wage cut necessary for employment to be increased. And this is precisely how Keynes defined involuntary unemployment: the willingness of workers to increase the amount of labor actually supplied in response to a price level increase that reduces their real wage.

Interestingly, in trying to explain why nominal-wage cuts would fail to increase employment, Keynes suggested that the redistribution of income from workers to entrepreneurs associated with reduced nominal wages would tend to reduce consumption, thereby reducing, not increasing, employment. But if that is so, how is it that a reduced real wage, achieved via inflation, would increase employment? Why would the distributional effect of a reduced nominal, but unchanged real, wage be more adverse to employment han a reduced real wage, achieved, with a fixed nominal wage, by way of a price-level increase?

Keynes’s explanation for all this is confused. In chapter 19, where he makes the argument that money-wage cuts can’t eliminate involuntary unemployment, he presents a variety of reasons why nominal-wage cuts are ineffective, and it is usually not clear at what level of theoretical abstraction he is operating, and whether he is arguing that nominal-wage cuts would not work even in principle, or that, although nominal-wage cuts might succeed in theory, they would inevitably fail in practice. Even more puzzling, It is not clear whether he thinks that real wages have to fall to achieve full employment or that full employment could be restored by an increase in aggregate demand with no reduction in real wages. In particular, because Keynes doesn’t start his analysis from a full-employment equilibrium, and doesn’t specify the shock that moves the economy off its equilibrium position, we can only guess whether Keynes is talking about a shock that had reduced labor productivity or (more likely) a shock to entrepreneurial expectations (animal spirits) that has no direct effect on labor productivity.

There was a rhetorical payoff for Keynes in maintaining that ambiguity, because he wanted to present a “general theory” in which full employment is a special case. Keynes therefore emphasized that the labor market is not self-equilibrating by way of nominal-wage adjustments. That was a perfectly fine and useful insight: when the entire system is out of kilter; there is no guarantee that just letting the free market set prices will bring everything back into place. The theory of price adjustment is fundamentally a partial-equilibrium theory that isolates the disequiibrium of a single market, with all other markets in (approximate) equilibrium. There is no necessary connection between the adjustment process in a partial-equilibrium setting and the adjustment process in a full-equilibrium setting. The stability of a single market in disequilibrium does not imply the stability of the entire system of markets in disequilibrium. Keynes might have presented his “general theory” as a theory of disequilibrium, but he preferred (perhaps because he had no other tools to work with) to spell out his theory in terms of familiar equilibrium concepts: savings equaling investment and income equaling expenditure, leaving it ambiguous whether the failure to reach a full-employment equilibrium is caused by a real wage that is too high or an interest rate that is too high. Axel Leijonhufvud highlights the distinction between a disequilibrium in the real wage and a disequilibrium in the interest rate in an important essay “The Wicksell Connection” included in his book Information and Coordination.

Because Keynes did not commit himself on whether a reduction in the real wage is necessary for equilibrium to be restored, it is hard to assess his argument about whether, by accepting reduced money wages, workers could in fact reduce their real wages sufficiently to bring about full employment. Keynes’s argument that money-wage cuts accepted by workers would be undone by corresponding price cuts reflecting reduced production costs is hardly compelling. If the current level of money wages is too high for firms to produce profitably, it is not obvious why the reduced money wages paid by entrepreneurs would be entirely dissipated by price reductions, with none of the cost decline being reflected in increased profit margins. If wage cuts do increase profit margins, that would encourage entrepreneurs to increase output, potentially triggering an expansionary multiplier process. In other words, if the source of disequilibrium is that the real wage is too high, the real wage depending on both the nominal wage and price level, what is the basis for concluding that a reduction in the nominal wage would cause a change in the price level sufficient to keep the real wage at a disequilibrium level? Is it not more likely that the price level would fall no more than required to bring the real wage back to the equilibrium level consistent with full employment? The question is not meant as an expression of policy preference; it is a question about the logic of Keynes’s analysis.

Interestingly, present-day opponents of monetary stimulus (for whom “Keynesian” is a term of extreme derision) like to make a sort of Keynesian argument. Monetary stimulus, by raising the price level, reduces the real wage. That means that monetary stimulus is bad, as it is harmful to workers, whose interests, we all know, is the highest priority – except perhaps the interests of rentiers living off the interest generated by their bond portfolios — of many opponents of monetary stimulus. Once again, the logic is less than compelling. Keynes believed that an increase in the price level could reduce the real wage, a reduction that, at least potentially, might be necessary for the restoration of full employment.

But here is my question: why would an increase in the price level reduce the real wage rather than raise money wages along with the price level. To answer that question, you need to have some idea of whether the current level of real wages is above or below the equilibrium level. If unemployment is high, there is at least some reason to think that the equilibrium real wage is less than the current level, which is why an increase in the price level would be expected to cause the real wage to fall, i.e., to move the actual real wage in the direction of equilibrium. But if the current real wage is about equal to, or even below, the equilibrium level, then why would one think that an increase in the price level would not also cause money wages to rise correspondingly? It seems more plausible that, in the absence of a good reason to think otherwise, that inflation would cause real wages to fall only if real wages are above their equilibrium level.

On a Difficult Passage in the General Theory

Published July 25, 2013 Earl Thompson , expectations , Fisher equation , inflation , Irving Fisher , Keynes , natural rate of interest 32 Comments
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Keynes’s General Theory is not, in my estimation, an easy read. The terminology is often unfamiliar, and, so even after learning one of his definitions, I have trouble remembering what the term means the next time it’s used.. And his prose style, though powerful and very impressive, is not always clear, so you can spend a long time reading and rereading a sentence or a paragraph before you can figure out exactly what he is trying to say. I am not trying to be critical, just to point out that the General Theory is a very challenging book to read, which is one, but not the only, reason why it is subject to a lot of conflicting interpretations. And, as Harry Johnson once pointed out, there is an optimum level of difficulty for a book with revolutionary aspirations. If it’s too simple, it won’t be taken seriously. And if it’s too hard, no one will understand it. Optimally, a revolutionary book should be hard enough so that younger readers will be able to figure it out, and too difficult for the older guys to understand or to make the investment in effort to understand.

In this post, which is, in a certain sense, a follow-up to an earlier post about what, or who, determines the real rate of interest, I want to consider an especially perplexing passage in the General Theory about the Fisher equation. It is perplexing taken in isolation, and it is even more perplexing when compared to other passages in both the General Theory itself and in Keynes’s other writings. Here’s the passage that I am interested in.

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

The statement is problematic on just about every level, and one hardly knows where to begin in discussing it. But just for starters, it is amazing that Keynes seems (or, for rhetorical purposes, pretends) to be in doubt whether Fisher is talking about anticipated or unanticipated inflation, because Fisher himself explicitly distinguished between anticipated and unanticipated inflation, and Keynes could hardly have been unaware that Fisher was explicitly speaking about anticipated inflation. So the implication that the Fisher equation involves some confusion on Fisher’s part between anticipated and unanticipated inflation was both unwarranted and unseemly.

What’s even more puzzling is that in his Tract on Monetary Reform, Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates, which is simply an extension of Fisher’s uncovered interest arbitrage condition (alluded to by Keynes in referring to “Appreciation and Interest”). So when Keynes found Fisher’s distinction between the nominal and real rates of interest to be incoherent, did he really mean to exempt his own covered interest arbitrage condition from the charge?

But it gets worse, because if we flip some pages from chapter 11, where the above quotation is found, to chapter 17, we see on page 224, the following passage in which Keynes extends the idea of a commodity or “own rate of interest” to different currencies.

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys. . . .

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a percent per annum in terms of money; the marginal efficiency of an asset, which is x percent in terms of money, will then be x – a percent in terms of wheat. Since the marginal efficiencies of all capital assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

So Keynes in chapter 17 explicitly allows for the nominal rate of interest to be adjusted to reflect changes in the expected value of the asset (whether a money or a commodity) in terms of which the interest rate is being calculated. Mr. Keynes, please meet Mr. Keynes.

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen. But any change in inflation expectations, by definition, cannot have been foreseen, because to say that an expectation has changed means that the expectation is different from what it was before. Perhaps that is why Keynes tied himself into knots trying to figure out whether Fisher was talking about a change in the value of money that was foreseen or not foreseen. In any equilibrium, the change in the value of money is foreseen, but in the transition from one equilibrium to another, the change is not foreseen. When an unforeseen change occurs in expected inflation, leading to a once-and-for-all change in the value of money relative to other assets, the new equilibrium will be reestablished given the new value of money relative to other assets.

But I think that something else is also going on here, which is that Keynes was implicitly assuming that a change in inflation expectations would alter the real rate of interest. This is a point that Keynes makes in the paragraph following the one I quoted above.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relativevly to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Keynes comes back to this point at the end of chapter 17, making it more forcefully than he did the first time.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

So what Keynes is saying, I think, is this. Consider an economy with a given fixed marginal efficiency of capital (MEC) schedule. There is some interest rate that will induce sufficient investment expenditure to generate enough spending to generate full employment. That interest rate Keynes calls the “neutral” rate of interest. If the nominal rate of interest is more than the neutral rate, the amount of investment will be less than the amount necessary to generate full employment. In such a situation an expectation that the price level will rise will shift up the MEC schedule by the amount of the expected increase in inflation, thereby generating additional investment spending. However, because the MEC schedule is downward-sloping, the upward shift in the MEC schedule that induces increased investment spending will correspond to an increase in the rate of interest that is less than the increase in expected inflation, the upward shift in the MEC schedule being partially offset by the downward movement along the MEC schedule. In other words, the increase in expected inflation raises the nominal rate of interest by less than increase in expected inflation by inducing additional investment that is undertaken only because the real rate of interest has fallen.

However, for an economy already operating at full employment, an increase in expected inflation would not increase employment, so whether there was any effect on the real rate of interest would depend on the extent to which there was a shift from holding money to holding real capital assets in order to avoid the inflation tax.

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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