Noah Smith wonders if "reality might topple a beloved economic theory". Well, if you look at Sweden, reality just confirmed that beloved economic theory. The Riksbank raised interest rates because it was scared that low interest rates would cause financial instability. Lars Svensson resigned in protest. Then inflation fell, and the Riksbank needed to cut interest rates even lower than before.
That's only one data point. But there are loads more.
If you don't know how to drive a car, and you don't even have a clue whether you turn the steering wheel clockwise or counter-clockwise if you want to turn right, one good strategy is to borrow a car, and a wide open field, and experiment. Make a random turn of the wheel, and see what happens. The recent data point in Sweden was a natural experiment like that. But Sweden is not a wide open field, and it's hard to borrow a car to experiment like that on regular roads.
An alternative strategy is to ask an experienced driver which way to turn the wheel. Preferably a driver who has managed to keep his car out of the ditch for the last 20 years. Like the Bank of Canada. And if the Bank of Canada says that it cuts interest rates when inflation is falling below target, and it wants to bring inflation back up to target, you listen. They are either right, or wrong and very very lucky.
Never ignore the advice of experienced practitioners, who have had their hands on the steering wheel for a very long time. Unless you have a very good theory about why they might be deluded.
Theory says, and the data confirm, and the advice of experienced practitioners confirms, that if it wants to raise inflation the central bank should first lower interest rates. Then, when inflation and expected inflation starts to rise, it can raise interest rates, higher than they were before. Then, and only then, does the Fisher effect kick in, and we see a positive correlation between inflation and nominal interest rates. That is the Scandinavian flick we saw recently in Sweden. [Except the Riksbank did the flick the wrong way round, so Lars "The Stig" Svensson jumped out of the Saab and watched it go into the ditch from the sidelines.]
But cars don't have to work that way, and monetary policy doesn't have to work that way either. If we wanted to, we could design a way of implementing monetary policy so that the central bank would increase inflation by raising interest rates.
For example, we could make it a rule of central banking that central banks are not allowed to issue new money except by paying interest on old money. So that if the central bank raised the interest rate it pays to people who hold central bank money from 0% to 5%, the growth rate of the money supply also rises from 0% to 5%. And the increased money growth rate would also increase the inflation rate by 5 percentage points, eventually, for absolutely standard monetarist/keynesian reasons. And that is exactly what is going on in John Cochrane's model that Noah refers to. It is really very very simple and old-fashioned, when you finally get underneath all the fancy stuff.
But central banks, right now, do not in fact work like that. They do pay interest on reserves, but they also do (very large amounts of) open market operations. ("QE" is the silly new word for the open market operations that central banks have been doing for centuries.) There is no link between the central bank raising interest rates and raising money growth rates. Under current operating procedures, the link works in the opposite direction (just look at the data). So it just won't work.
Oh God. Figuring out the intuition behind John Cochrane's paper, to see what was really going on in his model, really drained me. Do I really have to wade through that Stephanie Schmidt-Grohe and Martin Uribe paper too, and reverse-engineer their result as well? I'm too old for this. Don't any of you young whippersnappers have an economic intuition? Do you all get snowed by every fancy-mathy paper that comes along?
I expect I will have to. Pray for me.