Bill Gross Gets Inside Fed's Head on Rates
China’s stock market has crashed. A Greek default is certain. The euro looks shaky. U.S. economic data is weak. Inflation is below target. So why on Earth is the Federal Reserve on course to raise interest rates, a move usually designed to slow an overheating economy?
According to a recent speech by Fed Chair Janet Yellen, a rate hike is imminent:
"I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy," Yellen said in prepared remarks. "I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step."
Bill Gross, the former PIMCO bond king, has a theory about why this is happening. He says the Fed, in essence, needs to raise rates just to prove that the U.S. economy doesn’t need low rates to function.
Gross may be on to something. Just as the Fed is making the decision whether to raise rates, a far more theoretical argument is playing out in the halls of academia. The key question is: “What happens when a central bank fixes interest rates at a certain level forever?”
The traditional answer to this question -- the answer embraced by New Keynesians, the dominant school within macroeconomics -- is that the economy will become unstable. If the Fed fixes the interest rate too low, eventually we will get runaway inflation. If it fixes the interest rate too high, eventually the economy will collapse and we will get runaway deflation.
Now, this isn’t so crazy, if you think about it. An interest rate peg is a price control, since interest rates are the price of borrowing money. It isn’t crazy to think that if the government tries to maintain a fixed price in a market for all eternity, eventually it will produce distortions or that market will stop functioning.
But suppose the economy doesn’t explode? What happens then? A small group of macroeconomists, including John Cochrane of the University of Chicago, have been arguing that a permanent interest rate peg must eventually cause the rate of inflation to move in the direction of the interest rate. In other words, if the Fed keeps interest rates low forever, inflation will eventually go low and stay low. This idea, called Neo-Fisherianism (because it relies on an equation called the Fisher Equation), threatens to turn everything we know about monetary policy on its head. If low interest rates cause low inflation instead of high inflation, it means that the Fed -- and every central bank in the world -- is doing things all wrong.
At the National Bureau of Economic Research’s Summer Institute, this idea got some pushback from a very heavy hitter. Michael Woodford, perhaps the most influential monetary economist in the world, gave a talk explaining why he thinks the Neo-Fisherians are wrong.
Basically, Woodford’s argument is this. The Neo-Fisherian idea relies heavily on the notion that people in the economy are hyper-rational -- that they can do an infinite series of calculations in their heads. Woodford shows that if people are even a tiny bit limited in their ability to process information -- just the tiniest smidgen! -- the Neo-Fisherian result reverses itself, and there’s no way for the Fed to maintain a fixed interest rate for all eternity. He shows that if expectations adjust even slightly imperfectly to changing realities, then the New Keynesian result -- that a fixed interest rate must eventually cause the economy to break down -- is the only possible result (at least, within the class of models that central banks currently work with).
This did not satisfy Cochrane. Cochrane, like many macroeconomists, believes that perfectly rational, infinitely intelligent expectations are the only way to go in macroeconomics. But most people probably believe that the economy is not infinitely intelligent or infinitely rational. It will be interesting to see how Cochrane and the Neo-Fisherians ultimately respond to Woodford.
In any case, this academic controversy probably gives some insight into the Fed’s eagerness to raise interest rates above zero. Actually, we really don’t know what happens when we try to keep interest rates fixed at a certain level forever. If the Neo-Fisherians are right, then we get permanent low inflation or even deflation, of the kind Japan has been experiencing for two decades now. If Woodford and the New Keynesians are right, we get explosive inflation. Both of those outcomes are bad.
So the Fed isn’t sticking around to find out who’s right. Better, in the minds of Fed officials, to move rates back into positive territory, where they have room to move them around in either direction. In other words, Gross’s interpretation of the Fed doesn’t seem crazy at all.
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