Nick Rowe has another post criticizing the Neo-Fisherian claim that pegging nominal interest rates at a high level would raise inflation to a higher level. Nick points out that in a model where interest rates are the central bank’s policy tool, the equilibrium is extremely unstable.
In my view the best way to see the problem with Neo-Fisherism is to first consider the situations where it is correct, and then ask what’s wrong with the actual claims being made.
In an earlier post I discussed the situation where Japan had a long-term trend rate of inflation of zero percent, and the US trend rate was 2%. The BOJ wanted to raise their trend rate to 2%, at least in the long run. How would a Neo-Fisherite do this?
One easy way is to simply peg the yen to the dollar. Because PPP tends to hold in the ultra-long run (many decades), Japanese inflation would be expected to rise to 2% on average, although year-to-year changes might be rather erratic. And because interest parity holds very well, even in the short run, Japanese interest rates would immediately rise to US levels. BTW, to do this thought experiment right, you’d want to assume it was done in 2016, by which time US short-term rates will be higher than Japanese short-term rates. You’d like Japanese interest rates to rise immediately.
Of course an immediate rise in short-term Japanese interest rates resulting from a change in monetary policy might be contractionary. But the BOJ has multiple policy tools, and any contractionary impact can be offset by a suitable one-time depreciation in the yen, before it is permanently pegged to the dollar. And BTW, if Japan wants 5% inflation they simply need to have a crawling peg, with the yen falling 3%/year against the dollar.
Can this work in a closed economy model, or is it simply a beggar-thy neighbor policy? Yes, it can work in a closed economy model. Instead of pegging the yen to the dollar, do a policy of pegging it to gold (or a basket of commodities), and then depreciating the currency by 2% per year against gold (or that basket.) Now that would be a policy deserving of the name “Neo-Fisherian!”
Ironically, the basic problem with Neo-Fisherism is that it’s way too Keynesian. The entire discussion is done using Keynesian assumptions—that control of interest rates is what we mean by “monetary policy.” So when they talk about raising the interest rate peg to a higher level, people naturally assume that this is to be done in the way that Keynesians would raise interest rates, via tighter money. But tighter money won’t raise the rate of inflation—hence the ridicule. In fact, Neo-Fisherism is perfectly fine if they’d spell out that they plan to raise interest rates via easier money, as with an exchange rate peg, or a crawling commodity price peg. Interest rates are only one of many possible policy tools, and in some ways the worst tool because the short-term effect of changes in M on interest rates is often the exact opposite of the long-term effect. That’s what leads to the instability (or “fragility”) problem identified by Nick.
PS. Switzerland adopted the policy discussed above just a few years back (depreciate the franc and then peg it to the euro at 1.2.)