John Cochrane has an excellent (and fairly long) post on monetary policy. He starts by discussing the pessimistic view of current Fed policy. Taylor Rule models suggest that we need much higher interest rates to get on top of the inflation problem—to get high enough real interest rates to drive inflation down. Then he discusses a more optimistic view of the Fed:
But what if expectations are rational? Here’s a little modification of the model with the arrows pointing to the changes. What if, the real interest rate and the Phillips curve are centered at expected future inflation rather than lagged inflation? Same simulation: Put in the federal funds rate path, anchor inflation at last year’s inflation. Turn off all shocks. What happens? I obtain almost exactly what the Federal Reserve is projecting.
Intuitively, the rational expectations Phillips curve looks at inflation relative to future inflation. Unemployment is low, as it is today, when inflation is high relative to future inflation. Inflation high relative to future inflation means that inflation is declining. And that’s exactly what this projection says. Rational expectations means you solve models from future to present. If people thought inflation was really going to be high in the future, inflation would already be high today. The fact that it was only five percent tells us that it’s going to decline and go away.
To be clear I don’t think the Fed thinks this way procedurally. They have a gut instinct about inflation dynamics, informed by lots of VAR forecasts and model simulations. But this theory gives a pretty good as-if description, a slightly more micro founded model that makes sense of those intuitive beliefs.
So the Federal Reserve’s projections are not nuts! Inflation might just go away on its own! There is a model that describes the projections. And this is a perfectly standard model: it’s the new-Keynesian model that has been in the equations if not the prose of every academic and central bank research paper for 30 years. So, it is not completely nuts. Our job is to think about these two models and think about which one is right about the world.
Cochrane points out that financial markets also believe that inflation will subside:
The markets, by the way, seem to agree with the Fed. Until the Fed started saying it’s going to move, markets also seemed to think inflation would go away all on its own.
I am a big fan of the rational expectations/efficient markets approach to macro, so I find that argument to be quite appealing. Of course there is no guarantee that the markets will be correct. Market inflation forecasts a year ago turned out to be incorrect as the Fed unexpectedly abandoned average inflation targeting. But Cochrane is right that controlling inflation doesn’t necessarily require high interest rates. A credible anti-inflation policy pushes inflation expectations much lower than current inflation, making the necessary adjustment in rates much less painful.
This is the central paradox of monetary policy. The most effective policies often (not always) look to average people like the least effective policies.
I slightly part company with Cochrane when he veers close to NeoFisherism:
Another, more uncomfortable way of putting the question,
- Is the economy stable or unstable with an interest rate that reacts less than one for one to past inflation?
The Fed’s projections say, stable. If we just leave interest rates alone, eventually, inflation will settle down. There may be a lot of short-run dynamics on the way, which these models don’t capture. But it settles down in the end. This answers Larry’s [Summers] last question. It’s not necessarily a mistake. This is a model of the world in which nominal things do control nominal things, and the nominal interest rate eventually drags inflation along with it. A k percent interest rate rule is possible. Not necessarily optimal, but possible.
I was with Cochrane until he used the NeoFisherian term “drags”, instead of “follows”. The “nominal things” the Fed does to drag inflation down is controlling the nominal supply of base money and the real demand for base money. Turkey tried to drag inflation down with low interest rates. It didn’t work. Never reason from a price change.
Again, policies that lead to low interest rates are often contractionary (as Cochrane suggests). But lowering interest rates is not in itself contractionary.
Cochrane then applies the fiscal theory of the price level to the US, but it’s not a good fit. There’s no doubt that fiscal deficits drive inflation in places like Venezuela. But the Fed did not create the Great Inflation of 1966-81 because it was trying to finance fiscal deficits (which were quite small at the time.) It printed money in a misguided attempt to create jobs. The Fed is the dog and fiscal policymakers are the tail.