WTF!? Neo Fisherianism as one social construction of reality

Macroeconomists need to pay more attention to finance sociology. Choke.

Languages have multiple equilibria. If we all used the word "cat" to mean dog, then "cat" would mean dog. And if I walked into a pet store and said "I want to buy a cat", the people in the pet store would react differently to how they react today. They would bring me a dog, not a cat.

The effect of my action depends, in part, on how people interpret that action. What does it mean? Why did Nick say/do that?

Suppose the Bank of Canada targets 2% inflation, using a nominal interest rate instrument. Suppose the economy is humming along in full rational expectations equilibrium, with inflation at 2%, nominal interest rate at 3%, and nobody expects it to change.

Now suppose the Bank of Canada suddenly and unexpectedly raises the interest rate to 4%. But the memo explaining why it did that gets lost. How would people react to the Bank of Canada's action?

The initial reaction would be: "WTF!?"

Both the "!" and the "?" are important. It's a surprise, and they don't know what it means. They don't know why the Bank of Canada did it. And the effect the Bank of Canada's action will have on the economy depends very much on how people interpret that action. On what they decide it means. On what they decide about why the Bank of Canada did it. It's a signal, of something, but what is it a signal of? Monetary policy is a signalling equilibrium.

This is not a mechanical question. The monetary "transmission mechanism" is very different from a car's transmission. It isn't all about concrete steppes.

Eventually the Bank of Canada's memo gets published on the web. Here are four possible memos explaining why the Bank did what it did:

1) "Our new information/model shows demand is going to be much stronger than our old information/model says it was, and we need to raise real interest rates to prevent inflation rising above the 2% target."

2) "We decided to increase the inflation target from 2% to 3%, figured expected inflation would rise very quickly to the new target, and didn't want real interest rates to drop."

3) "We've turned Swedish, and decided to raise the overnight rate to reduce asset prices, even if it means inflation drops below the 2% target temporarily."

4) "The person responsible has been fired, and normal monetary policy will resume shortly."

We are not going to get the same response across all 4 cases.

[Yes I'm guilty of self-plagiarism. Re-cycle, re-use. If it were only this easy to get a downstream O2 sensor off a junked Tercel at Kenny U-pull.]

In Canada today, memo 1 is most plausible, but we can't rule out memo 3 (or even memo 4). Memo 2 would almost certainly be posted well before the Bank raised the nominal interest rate.

Neo-Fisherians (who say raising the nominal interest rate will cause inflation to increase) are implicitly assuming memo 2. Or rather, they don't mention memos at all, but are implicitly assuming that people will interpret the Bank of Canada's action in line with memo 2.

What happens if memo 2 is in fact published on the web, but some people don't get the memo, and assume it must have been memo 1 that got published, like normal? And the people who did get the memo know that some fraction of the population won't have got the memo, and will assume it's memo 1 that got posted? The people who didn't get the memo are going to cut their own spending (figuring someone else will spend more to make up for it and keep inflation on target). The people who did get the memo are going to figure out that the people who didn't get the memo are going to cut their spending, and that nobody else will make up for it, so that demand will drop, and so output and inflation will drop.

We can't get the Neo-Fisherian result unless everyone gets the memo, and interprets the Bank of Canada's action the same way. Ain't gonna happen. You can't change languages instantly like that. Some people will still think that "cat" means cat, until they eventually learn the language has changed by watching what other people do.

But if the Bank of Canada issued memo 2, and at the same time raised the nominal interest rate by less than the announced increase in the inflation target, to make up for the fact that not everyone will get the memo initially, and then resumed normal play of issuing memos like memo 1, depending on the speed at which the slower people got the memo (which will look like following the Howitt/Taylor principle), then something like that would work.

[Damn I'm spending too much time on this N-F topic.]

Comments

[louis]

Nice post, I like how you laid out the alternatives.
The weird thing is that this discussion is happening in the context of inflation running below the original target. Let's say everybody gets the memo that the CB is increasing its inflation target from 2% to 3%, and raising the nominal rate by any portion of that. The rational or at least modal response will still likely be to expect a fall in inflation, because the credibility of the target is dubious and the CB is stepping in the wrong direction from what's needed to establish that credibility.
Your framework makes more sense than, and is very distinct from, the crude N-F argument "inflation is lower than target BECAUSE nominal rates are too low, and raising nominal rates is necessary to get inflation back to the original target".

[Nick Rowe]

louis: thanks. Yep, not everyone believing the memo is like not everyone getting the memo. You still need some sort expectations about off-the-equilibrium-path play by the Bank of Canada (something like the Howitt/Taylor principle) to make the memo credible. But I'm being fully Neo-Wicksellian in this post (assuming the nominal interest rate plus memo are the only things in the central bank's strategy space). And that strategy space itself is a social construction of reality. If the Bank plays M, instead of playing i, it makes a lot of difference, just like Cournot Nash equilibrium (where the firms play Q) is very different from Bertrand Nash equilibrium (where the firms play P).

[Majromax]

The memo's credibility also partially depends on the "concrete steppes." If contrarians who don't believe the memo can profit by acting on that belief, then the bank's memo is irrelevant.

Take memo #2, with the Bank of Canada's current method of operation. If I am a retail bank that doesn't believe the Bank of Canada, then I expect less than 3% inflation. Suppose I expect inflation to be sticky at 2% for a few months to a year -- then I will profit by leaving capital in the form of reserves, earning a greater-than-(2% + 1% real) deposit rate. This action of mine does not increase aggregate demand, however (and may even reduce it if I reduce other lending), which lowers or does not increase the price level.

Now, take memo #2, but imagine also that the Bank of Canada operated by paying interest on both currency and reserves. This is the world of last year, and here there is no benefit to me-as-a-retail-bank changing my reserve policies relative to the status quo.

[Nick Rowe]

Majro: forget all that finance/banking rubbish. Signalling is much more important. What the Bank needs is a combination of memos 2 and 1'. The memo would read "We are targeting 3% inflation, but in addition will continue to adjust i conditional on how many people do not believe (or get) the memo". All you need is 1% of the population to think it might maybe work a bit, and 99% to have rational expectations (or slowly learn from experience), and you get (slow) liftoff. Or use forward guidance (or QE) instead.

[Market Fiscalist]

I am clearly an unassimilated immigrate from the Concrete Steppes because I can't stop looking for something other than expectations to drive the Neo-Fischerian higher inflation equilibrium.

What about:

- Higher interest rates will lead to higher interests payments and (probably) greater wealth for some people as this interest compounds. This would eventually have a significant positive effect on AD to counteract the initial deflation.
- Higher interest rates would lead to higher costs for borrowers. Likewise this would counteract the deflationary effects of the interest rate rise by at least slowing down its extent.

I suspect you could build a model where these forces would eventually reverse the deflationary cycle and drive the increased-inflation outcome.

[Kenneth Duda]

HI Nick, I like this post even more this time than last time :-)

What I like about it is: The concrete-steppes people object to NGDPLT because they can't see a transmission mechanism for monetary policy at the ZLB. The argument you make here nails it. The transmission mechanism is expectations. If the market knows that the monetary base expansion is as permanent as needed to hit the NGDP level target, then you can boost AD with a lot less QE.

-Ken

Kenneth Duda
Menlo Park, CA

[Nick Rowe]

MF: "Neo-Fischerian" there's a very much alive economist called Fischer with a C, who will be coming after you for associating him with that view! The Fisher without a C can only haunt us.

You only need 1% concrete steps. And those concrete steps can be future steps, not present steps. And they can be threatened steps, about what the Bank *would* do if, counterfactually, we disobey the memo, and not actual steps.

"What about:"

God no! That's recycled Post Keynesian stuff from the 1970's and early 1980's, when they used those exact same arguments to say that the Bank's raising interest rates would cause inflation to rise even higher. They were wrong then (because inflation fell), and they are still wrong now.

Thanks Ken! But see the first bit of my response to MF above. But yes, an announced *permanent* increase in the base (or the threat of a permanent increase in the base unless there's a permanent increase in NGDP), is very different from the QE we've seen. What does QE mean? Is it temporary or permanent? What's the target it is being used to hit? Under what conditions would it stop? Those are all far more important than the QE itself. Actual QE would almost certainly have to be negative, if the Fed sent the right memo.

[Min]

"Now suppose the Bank of Canada suddenly and unexpectedly raises the interest rate to 4%."

Return to Neverland. ;)

[Tom Brown]

Good post Nick, but I'm still struggling with connection to the World Taekwondo Federation.

[Tom Brown]

...and you're probably right about time spent on an N-F topic, especially one written in English. (not sure they'll understand!)

OK, sorry. Let me do the honors: I'll tell myself: "Stop commenting on this post now!"

[Market Fiscalist]

Nick,

I'm not consciously channeling Post-Keysianism here. I thought about the model a bit and came up with this:

The CB initially introduces money into an economy by buying a bunch of assets and then does monetary policy by setting an interest rate at it which it will lend to any borrower and pay interest to any saver.

People's income consist of 1) money received from selling goods and services and 2) Interest income from CB (this may be negative). They save from this income based on current real interest rates (nominal - natural rate) and spend the rest.

(additional assumptions: The price level does not change when the economy is below capacity , and when above capacity NGDP = inflation. There is no productivity growth.)

Starts of with the interest rate at the natural rate. Savings equal borrowing and all is stable. There is no net interest income.

It then raises rates by 1% and holds them there for ever.

At first savings exceeds borrowing and NGDP falls.

Each year that savings exceeds borrowing accumulated savings grow and the CB pays out increasing amount of interest. Eventually spending from the interest payments exceeds net savings and NGDP growth goes positive.

At some point the economy reaches capacity and NGDP growth will lead to inflation, and saving will start to fall again (since real rates fall)

A new equilibrium will be reached with interest payments = 1% of NGDP. This will drive 1% NGDP growth and 1% inflation. Savings will exceed investment by 1% each year and we will have the higher inflation equilibrium.

[Market Fiscalist]

Corrections:

NGDP Growth = inflation
real interest rates = (nominal rate - inflation)

[W. Peden]

"The Fisher without a C can only haunt us."

It would be a good thing if he'd haunt us a bit more. We rightly give credit to Friedman on the importance of not identifying low/high interest rates with loose/tight money, but it's all very well expressed back in Fisher.

This year is the centenary of Fisher's "How to Live", which is fascinating as a (rather dark) piece of history of science.

[louis]

Nick - thanks for the clarification, though it took me two reads to get it.
I still think the strategy here is too convoluted to give any
Let's say the target inflation rate is 2%, but the actual rate has slipped to 1% for a few periods. You run the CB but only set i (and communications). How do you exit that trap? Seems all you can do is lower i and if you hit ZLB tell people "I mean it, i ain't going up until inflation is consistently at target". Even with the logic above, I can't see raising i as doing anything to help. Particularly since raising i probably involves OMOs that shrink the beloved M!

[Scott Sumner]

People want to debate the effect of central bank "gestures." But our models are silent on the effect of gestures; they only tell us the effects of different "regimes." Under the gold standard a positive monetary shock tended to lower interest rates, as expected inflation was generally near zero. When central banks switched to fiat money, they kept talking in that gold standard regime language, even though other languages were now possible, and indeed in some sense more accurate in the long run. It was now possible to change the trend rate of inflation.

If the Fed gestured toward higher interest rates tomorrow, that would be a signal of contractionary intent (gold standard language). If they shifted to a permanent regime of high nominal interest rates, that could well be a signal of expansionary intent (Neo-Fisherian language.)

When the EC demanded countries have low interest rates before they were allowed to join the euro, they did NOT mean, "We demand you have easy money before we let you join the euro." The EU was speaking Neo-Fisherian.

[Frances Woolley]

Nick, interesting post. No comment, just an ignorant question - you mention rational expectations, but the post basically starts with an anti-RE position that at least some people don't know the underlying model the bank is operating under. How many macro people believe RE models are the best way of describing the world these days? Or is the prevailing view that we always get to a RE equilibrium in the long-run, but it may take a while to get there, and so we need a theory about how expectations evolve when we're off the equilibrium path?

The digital detox was awesome, b.t.w.

[Nick Rowe]

Scott: funny you mention "gestures". I vaguely recall reading a story about Sraffa making a gesture to Wittgenstein, that caused Wittgenstein to change his philosophy of language. Or did Pasinetti tell me that? Can't remember.

The Bank of Canada speaks 2% inflation language. Given that language, all memos should be memo 1. Yep, it's similar to gold standard language. Neo-Fisherianism is a very different language, where all memos are memo 2. Neat point about the EU.

[Nick Rowe]

Frances: good to hear your digital detox session went well!

My reading of Lucas, back when RE was new, was very much a weak version of RE. People don't in fact know the underlying model, but they can spot correlations, given long enough, even if they have no idea what causes those correlations. And if their subjective rules of thumb for expectations don't match those observed correlations, those rules of thumb will change, so we are not in full RE equilibrium yet. But if the policy regime changes, we can't expect an instant change to those new rules of thumb that match the new correlations. Though announcements may help. And that is my view, and I think the view of sensible macroeconomists. But young people nowadays, well, they do tend to get carried away.

[Nick Rowe]

MF: " Savings will exceed investment by 1% each year and we will have the higher inflation equilibrium."

Unless you have a different definition of S and/or I, you just violated an accounting identity.

[pe]

but everything we do in social science and humanities is a social construction of reality. You are like the man who discovered he had been speaking prose all his life !

[Nick Rowe]

pe: everything chemists do is a social construction of reality. But that reality exists independently of chemists' theories. With social sciences the atoms themselves are constructing a shared reality.

But yes, there isn't anything that revolutionary here. Except for the people of the concrete steppes.

[The Market Fiscalist]

"Savings will exceed investment by 1% each year and we will have the higher inflation equilibrium.'

That was a typo. I actually meant 'Savings will exceed borrowing' which is possible in the model I describe where the CB does monetary policy by lending and taking deposits at whatever rate it is offering.

[Makrointelligenz]

I think your post sums up quite well the deficiencies of Neo-Fisherianism (which I think is more confusing than insightful). Memo 2 sums it all up.

[Tom Warner]

Okay how about we call them "reverse Fisherians" instead of "neo-Fisherians"? The point being they read the Fisher formula backwards from the way Fisher read it.

So we still for all practical purposes agree, and I'm still having none of even the little, tiny exception you try to allow with your hypothetical scenario in which "reverse Fisherian" theory could just possibly come true.

The scenario you describe is 1) not even remotely plausible, and 2) actually about the effect of raising the inflation target (yes, that does increase inflation expectations), not about the effect of raising policy rates (no, that doesn't).

Here's your scenario reworded:
1) all macro parameters are ideal and stable
2) the central bank for no objective reason decides to raise its inflation target by 100bps.
3) the central bank decides that to keep inflation jumping too far it needs to also raise rates by 200bps (notice you are incorporating the logic that rate hikes are a factor dampening inflation expectations, used here to counter-act step 2)
4) the central bank announces only the latter while keeping its intention to increase the inflation target secret.

The reaction would be a political and business community backlash seeking to force into retirement a central bank policy committee majority that has somehow suddenly all gone koo koo for cocoa puffs.

I get human signaling is different from mechanical transfer. Even though these days we actually have computers reading the policy announcements and moving the prices of assets that are sensitive to inflation instantaneously according to a pre-written program (which takes into account what the central bank was expected to do). Humans will ultimately decide how the market responds. And sometimes a central bank move is somewhat surprising and not explained and the market second-guesses to some extent. But markets care more about the policy than they do about the why of it. They usually respect central bankers' analyses but don't ascribe to them extraordinary knowledge or insight.

[Tom Warner]

Just to clarify a little, what I'm saying is that when a central bank makes a surprise move, there is a contest between two opposing effects:

A) People think: maybe the central bankers see something we're missing. If it's an unexpected tightening, this pushes expectations hotter.

B) People think: with current conditions as we know them, this means the central bank is either willfully or ignorantly pushing towards a different result than we thought. If it's an unexpected tightening, this pushes expectations cooler.

The contest is closer in times of uncertainty and when the surprise is smaller, but as a rule, B consistently wins.

[John Handley]

The neo-fisherian result is really more dependent on the status of fiscal policy than monetary policy. If the fiscal regime is both passive (surpluses react to the real level of debt by a factor of more than the real interest rate) and ricardian, conventional wisdom holds. If, however, fiscal policy is either completely exogenous (non-ricardian) or active, the inflation rate jumps with the nominal interest rate. Interest rate pegs are important too. If the economy is in an active fiscal/passive monetary regime but the nominal interest rate isn't pegged (i.e. follows a taylor rule that violates the taylor principle), a shock to the nominal interest rate causes inflation to fall initially and then go up with expected inflation until the nominal interest rate returns to normal. Basically, a neo-fisherian result is dependent on the fiscal theory of the price level and doesn't occur in a non-pegging, active monetary regime.

[Nick Rowe]

John (and Tom too): suppose the central bank speaks "M-dot language". It communicates its intention by announcing a change in the money supply growth rate. Suppose it announces an increase in M-dot. That will cause a higher equilibrium inflation rate, and higher expected inflation, and higher nominal interest rates. It will also cause an increase in seigniorage, and thus higher government spending or lower taxes (sooner or later), via the government budget constraint (and thus the fiscal theory perspective).

The problem with speaking i-language (nominal interest rate language) is that the dictionary that translates from i-language into M-dot language is ambiguous. Does an increase in i mean an increase or a decrease in M-dot? It could mean either, depending on what people interpret it to mean.

F-language (fiscal theory language) is also ambiguous. Does an increase in the current deficit signal a permanent increase (which implies an increase in M-dot), or does it imply a future surplus, so that M-dot can stay the same?

The above (I think) is Scott Sumner's way of looking at it. It makes sense.

[Nick Edmonds]

Whatever language the central bank speaks, what matters is what it will actually do in the future. This is not the same as what it says it will do, but it's not even the same as what it currently intends to do. There is no action the central bank can take to bind it's conditional actions long enough into the future to establish an RE equilibrium (ie forever).

If the central bank announced it was permanently raising the nominal rate in order to raise nominal inflation, I might believe that this was genuinely what it currently intended. But I would not believe that this policy would be permanent in the required sense. And that would be entirely rational, because I would turn out to be right.

[Nick Rowe]

Nick E: can we imagine an existentialist central banker, for whom each new day (or second) is a totally new day? Would an existentialist even be able to use language, or make decisions, at all? Certainly it's hard to imagine money, or language, in a world where everyone is an existentialist.

[Nick Edmonds]

There's a world of difference between one day to the next and permanent. The issue here is how long lasting does the interest rate change need to be to get the neo-Fisherite result and is it realistic to assume that can be maintained. My view is that the monetary authority cannot raise inflation by raising the interest rate because it is politically unable to deliver the commitment required. And people implicitly understand this.

[John Handley]

Nick: The assumption with the FTPL that makes it not ambiguous is that either surpluses are all exogenous and hence non-ricardian or that they follow a rule so that surpluses aren't reactive enough to debt thus forcing there to be a certain amount of seigniorage. I completely agree with the idea that changes in the money supply are more informative than the nominal interest rate at least in terms of determining the stance of monetary policy, but "FTPL logic" makes it so that an increase in the nominal interest rate must be consistent with more "looser" monetary policy. The whole thing is very ambiguous if fiscal policy is based purely on discretion (as it is in real life) so that monetary policy can be recieved differently based on how people expect fiscal policy to unfold in the future. I suppose the real problem is that the interest rate has a lot to do with the bond market whereas money doesn't (necessarily).

[John Handley]

To clarify, my last comment was addressed to Nick R. not Nick E.

[Tom Warner]

Well I'm very late answering, but I think rate targets are understood to be what they are, a commitment until further notice to provide or take away whatever amount of M0 keeps the targeted rate near the target. A higher rate unambiguously means less M0 all else equal, but I don't think markets care about translating that into an amount or a difference in growth rates. There was a brief fling with that idea in the heyday of monetarism in the '80s and the actual live M0 data proved to be too confusing. I do get all that you said about the ambiguity of signaling. But I still don't see any plausible scenario in which a rate hike causes majority inflation expectations to rise.