Reality Might Topple a Beloved Economic Theory

The easy money of quantitative easing is often seen as a way to prevent deflation and recession, but it might cause both.
More of it sometimes adds up to less.

So QE-infinity is done. Many and long will be the arguments about whether quantitative easing helped the U.S. economy, and what the costs were -- or will be. Most of those arguments will be between those who think quantitative easing just doesn't get much traction in the economy and those who think that it has a big effect.

But what if QE had the opposite of the intended effect? That is the claim of a small but well-credentialed group of macroeconomists that I once labeled the "Neo-Fisherites," after the famous monetary economist Irving Fisher. These economists wonder if quantitative easing reduced inflation, instead of increasing it as many feared it would. The Neo-Fisherites go even further than that -- they wonder if low interest rates, which we usually think of as being inflationary, are actually deflationary!

It sounds crazy. How could creating money lower the value of money in the long run?

The basic Neo-Fisherite intuition goes like this. Nominal interest rates are just (approximately) the sum of real interest rates and inflation:

r^nominal = r^real + inflation

This equation is called the Fisher Equation.

Most monetary economists -- and most people who watch the news -- think that if the Federal Reserve pushes r^nominal down, by printing money and buying bonds, that inflation goes up and r^real goes down by even more. But what if Fed money-printing can't affect real interest rates for more than a short while? What if real interest rates are ultimately determined not by anything the Fed does, but by the natural forces of supply and demand? What if r^real naturally goes back to some level -- say, 2 percent -- even if r^nominal stays low?

The answer is clear: Mathematically, inflation has to fall.

This idea is so heretical that even those economists who entertain the idea are generally reluctant to express much certainty. One of the earliest Neo-Fisherites was Minnesota Fed President Narayana Kocherlakota, who suggested in a 2010 speech that a long-term policy of ultra-low interest rates could lead to deflation. Kocherlakota later converted to a more conventional monetary point of view, and became a QE supporter.

But the banner of the Neo-Fisherites was taken up by Steve Williamson, formerly of Washington University and now of the St. Louis Fed. Williamson had been one of the many economists warning in 2010-2012 that QE could cause runaway inflation. But unlike the signatories of the famous 2010 open letter to former Fed Chairman Ben Bernanke, Williamson changed his model of the world when the world didn't seem to fit his old model. In 2013 he came out with a new paper suggesting a way that QE could be deflationary.

That paper touched off a firestorm of controversy in the blogosphere and behind certain closed doors in academia. Detractors of the idea claimed that there was no plausible mechanism by which low interest rates might cause deflation -- that it would be like umbrellas causing rain. Williamson's paper relied on fiscal policy -- that is, Congress -- doing some odd stuff in response to changes in Fed monetary policy.

At around the same time, prominent macroeconomists Stephanie Schmidt-Grohe and Martin Uribe came out with a paper suggesting the very same thing -- that raising interest rates would cause inflation to rise, and lowering rates would cause inflation to fall.

Now, the Neo-Fisherites have been joined by a very heavy hitter -- University of Chicago economist John Cochrane. In a new paper called "Monetary Policy with Interest on Reserves," he explains a mechanism by which higher interest rates raise inflation. Unlike Williamson's model, Cochrane's model obtains a Neo-Fisherian result without appealing to fiscal policy. In fact, he finds that in some cases, raising interest rates can even stimulate the economy in the short term! He concludes succinctly:

The basic logic is pretty simple: raising nominal interest rates either raises inflation or raises real interest rates. If it raises real interest rates, it must raise consumption growth. The prediction is only counterintuitive because for so long we have persuaded ourselves of the opposite[.]

Cochrane has a simple explanation of the model's key predictions on his blog. He hypothesizes that now that the Fed pays interest on the reserves that banks hold with the Fed, monetary policy will be even more Neo-Fisherian -- i.e., even more perverse.

Cochrane is half-kidding when he calls the Neo-Fisherite view "heretical." It certainly flies in the face of an overwhelming consensus, but Cochrane's arguments are based on simple equations that are at the heart of most modern macroeconomic models. If the Neo-Fisherites are right, then everything the Fed has been doing to try to stimulate the economy isn't just useless -- it's backward.

Now, the overwhelming majority of empirical studies tell us that QE, and Fed easing in general, tends to raise inflation in the short term. But what if that's at the cost of lower inflation in the long term? Japan has been holding interest rates at zero for many years, and its economy has been in and out of deflation. Massive QE has noticeably failed to make the U.S. hit its 2 percent inflation target. What if mainstream macroeconomics has it all upside down, and prolonged periods of low interest rates trap us in a kind of secular stagnation that is totally different from the kind Harvard economist Larry Summers talks about?

It's a disquieting thought.

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