The Bizarre Theory That Says Fed Increases Will Fuel Inflation

Could a Fed Rate Increase Actually Spur Inflation?
  • `Neo-Fisherians' reevaluate link between rates and price gains
  • Persistently low inflation raises questions on economic theory

Many economists are so perplexed by the lack of inflation in the U.S. after years of unprecedented monetary stimulus that a bizarre, century-old theory is suddenly gaining traction: Maybe higher interest rates are what’s needed to push up consumer prices.

The idea runs counter, of course, to basically everything taught in Economics 101 classes (higher rates, we’re told, discourage rather than encourage spending and therefore curb inflation). But near-zero borrowing costs have done so little to trigger inflation that several prominent economists including John Cochrane, a senior fellow of the Hoover Institution at Stanford University, have dusted off the theory and are trying to apply it to today’s sluggish expansion. Key to the argument is the idea that higher rates will make people think the economy is doing better and, as a result, they’ll start spending more. In other words, project strength and strength (as well as a little inflation) will follow.

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"When there’s a debate, people say we’re nuts," said Cochrane. But after the Fed cut interest rates near zero, "there was no spiraling deflation. There was no hyperinflation. It’s remarkable."

The theory will get put to the test soon enough. Federal Reserve policy makers are widely expected to start lifting benchmark borrowing costs Wednesday. Inflation is almost non-existent, with consumer-price index gains running at an annual pace of just 0.5 percent. Those looking to see higher inflation -- including the Fed itself -- argue that rising prices would help foster a more robust expansion seven years after the financial crisis throttled growth.

The Fed’s preferred measure of price growth, the personal consumption expenditure core price index, rose 1.3 percent in October from a year earlier. The U.S. central bank’s target for that measure is 2 percent.

Neo-Fisherians

In the late 19th century, the economist Irving Fisher was the first to put forth the idea that rising rates could lead to more inflation. His growing band of followers has earned the label Neo-Fisherians.

In addition to Cochrane at Stanford, Stephen Williamson, an economist at the St. Louis Federal Reserve, has been a proponent of the concept and Columbia University economists Stephanie Schmitt-Grohe and Martin Uribe came up with a model that says raising rates can boost inflationary expectations and employment. Even Federal Reserve Bank of St. Louis President James Bullard has flirted with the idea. He said in August and November speeches that it’s possible the U.S. economy could reach a state where there’s stable, low inflation because the Fed has kept interest rates near zero.

Opposite Effect

Higher rates and inflation would be good for those who have already done most of their borrowing, since it makes their debt worth less. But it raises borrowing costs for pretty much everyone else.

It could also make loans more profitable for banks, which may lead them to step up lending to consumers and companies, according to Brian Jacobsen, chief portfolio strategist at Wells Fargo Advantage Funds, which manages $242 billion in Menomonee Falls, Wisconsin. The worst-case scenario is probably an asset bubble, he said.

If the Neo-Fisherian theory were proven correct and inflation does start to quicken after rates are increased, that’s an outcome central bankers would endorse. Typically, they’re looking to achieve the exact opposite when they lift rates. But the current circumstances in the U.S. and Japan are leading some intellectuals to rethink the most established economic dogma.

"There’s a lot of uncertainty about just how things will work," said Cochrane. "Certainly, it argues for caution. Things may turn out differently than you think."

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