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Don't Try This Crazy Trick on the Economy

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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Some economists argue that the Federal Reserve should take a highly unconventional approach to ending a long period of below-target inflation: Instead of keeping interest rates low to spur economic activity and push up prices, it should raise rates.

Labeled "Neo-Fisherism" by my Bloomberg colleague Noah Smith (after the famous monetary economist Irving Fisher), it's an idea I once entertained. Allow me to explain why I now think it’s dangerous.

Neo-Fisherites believe that modern economies are self-stabilizing. Specifically, they think that, regardless of what monetary policy makers do or don’t do, the real interest rate -- the rate that matters for people's and businesses' decisions to borrow and spend -- has to adjust over the longer run to ensure that the economy is in equilibrium. Because the real rate consists simply of the nominal rate minus inflation expectations, this leads to some unusual policy recommendations.

Suppose, for example, the long-run equilibrium real rate is 2 percent. Neo-Fisherites would predict that if the Fed holds nominal rates at 0.5 percent for too long, people's inflation forecasts will eventually have to turn negative -- to minus 1.5 -- to get the real rate back to 2. Conversely, if the Fed raises its rate target to 4 percent and keeps it there, inflation expectations will rise to 2 percent. Because such expectations tend to be self-fulfilling, the result will be precisely the amount of inflation that the Fed is seeking to generate.

Traditional economic models, by contrast, predict the opposite. If the central bank raises rates and credibly commits to keeping them high, people and businesses become less willing to borrow money to invest and spend. This undermines demand for goods and services, putting downward pressure on employment and prices. As a result, the economy can plunge into a deflationary spiral of the kind that afflicted the U.S. in the early 1930s.

So who’s right? Let's look at the recent evidence in the U.S. Here's a chart showing the short-term interest rate that the Fed controls, along with a measure of longer-term inflation expectations derived from the prices of Treasury securities:

The Fed held the nominal interest rate near zero from late 2008 until late 2015 -- a policy that, according to Neo-Fisherites, should have driven inflation expectations into negative territory. Yet they stayed roughly the same for most of that period. They started to slide downward only after the Fed began to tighten policy in May 2013 by signaling that it would pull back on the bond purchases known as quantitative easing. Also, the recent modest increase in the nominal rate has not led to a commensurate increase in inflation expectations.

Granted, that’s just one piece of evidence from one country. Nonetheless, it would be remarkably irresponsible to take the risk of raising rates based purely on a theoretical belief in macroeconomic self-stabilization.

I, too, once believed that the horrific events of the early 1930s, when economic output fell by a quarter and prices by even more, could not recur in a modern capitalist economy like the U.S. Then 2008 happened, and we all learned where a religious belief in the self-correcting nature of markets can lead us. If we want stability, we have to choose the right policies. Raising rates in the face of low inflation is not one of them.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net