The Neo-Fisherian debate continues, and continues to miss the point. The debate is framed in terms of whether a higher interest rate causes higher inflation. But that’s not even a question. Or at least it’s meaningless unless you explain whether the higher interest rate is produced by an expansionary monetary policy or a contractionary monetary policy. Central banks have the tools to do it either way. On the other hand I am increasingly getting the impression that the New Keynesian model is incapable of handling that distinction. Here’s John Cochrane responding to a recent Woodford talk on the issue:
This is a particularly important voice, as it seemed to me that standard New-Keynesian models produce the new-Fisherian result. i = r + Epi is a steady state in all models. In old-Keynesian models, it was an unstable steady state, so an interest rate peg leads to explosive inflation or deflation. But in new-Keynesian models, an interest rate peg is the stable/indeterminate case. There are too many equilibria, but if you raise interest rates, inflation always ends up rising to meet the higher interest rate.
What I can glean from the slides is that Garcia Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away.
My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.
But that’s only preliminary relief. Schmidt and Woodford promise a paper soon, which will undoubtedly be well crafted and challenging.
If that’s true, then the NK model is obviously very, very flawed. Noah Smith seems to agree that rational expectations is the key assumption:
The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational. Woodford’s new idea – which will certainly be a working paper soon – is that people don’t adjust their expectations to infinite order. He essentially puts bounded rationality into macro. He posits a rule by which expectations converge to rational expectations.
I have one small quibble here. When Smith writes:
The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people’s expectations are infinitely rational.
He seems to imply that he is discussing the real world. Like it would actually matter whether people had ratex. My hunch is that you can easily get either result with or without ratex, if you don’t restrict yourself to the NK model. The liquidity effect from easy money should be able to be derived with simple sticky prices, even with ratex. I’d rather Smith had said:
The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way in the NK model depends on whether people’s expectations are infinitely rational.
BTW, in this post I showed how you could get a Neo-Fisherian result. That doesn’t mean I think they are “right”, just the opposite. But I am increasingly confident that they have stumbled on something important, a serious flaw in the NK model. I’d rather people continue to assume rational expectations, and fix the model in some other way—like defining monetary policy in terms of something other than interest rates. Stop assuming that “the central bank raises interest rates” is a meaningful statement. It isn’t.
PS. I wrote this a couple days ago but wasn’t sure if I was missing something, so I didn’t post until today. Nick Rowe’s new post convinced me that I’m not missing something obvious.
HT: Tyler Cowen