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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".

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).

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.

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.

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.

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.


Kenneth Duda
Menlo Park, CA

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.

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

Return to Neverland. ;)

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

...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!"


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.


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

"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.

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!

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.

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.

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.

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.

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.

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 !

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.

"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.

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.

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.

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.

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.

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.

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 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.

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.

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).

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

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.

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