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Monetarists Are Out of Ideas

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Steve Williamson of the Federal Reserve Bank of St. Louis for the past three years or so has been trying to convince the macroeconomics world to consider a bold new theory -- that central bank policy works in reverse, and that low interest rates cause low inflation. This is an idea sometime referred to as Neo-Fisherism. Recently, Williamson has challenged my Bloomberg View colleague Narayana Kocherlakota, formerly of the Federal Reserve Bank of Minneapolis, in an extended blog and Twitter debate on the subject. The result has been the deepest, most illuminating exchange about monetary policy ever posted on the internet.

Other than Kocherlakota, very few people have even engaged with the Neo-Fisherian idea. Certainly it doesn’t seem to have made much of a splash in the academic macro community, and even less in central bank circles, despite its dramatic and startling implications for policy. A few respected economists, such as John Cochrane, Stephanie Schmitt-Grohe, and Martin Uribe, have argued in favor of the idea, or something like it. And the highly respected Xavier Gabaix of Harvard has incorporated the idea into a new model . But the overall response has been muted in the halls of policy making and academia.

You would think macroeconomists and central bankers would be on the hunt for new ideas, since monetary policy doesn’t look like it’s doing anything right now. In the U.S., an extended period of low interest rates, accompanied by massive quantitative easing and forward guidance, didn’t seem to accomplish much; maybe it helped get inflation close to  the Federal Reserve's 2 percent target level, or it might have just been along for the ride. In Japan, the central bank’s mightiest efforts at easing -- the Bank of Japan now owns 60 percent of the country’s market for exchange traded funds -- produced nothing more than a brief, anemic burst of inflation. The country’s prices are now stagnant or falling again.
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Meanwhile, supporters of activist monetary policy are calling for new measures such as raising inflation targets, very negative interest rates, nominal gross domestic product targeting (which combines GDP and the inflation rate), and so-called helicopter money -- basically mailing checks to people. If these unconventional monetary policies had substantial, measurable effects on inflation and output, they would be the first ones to do so. Maybe doubling down on activist monetary policy would work, but another possibility is that the standard theory of how monetary policy works -- the general idea that low interest rates stimulate both inflation and the real economy -- is broken.

I have no idea whether Steve Williamson’s Neo-Fisherism is the answer. An alternative possibility is that monetary policy just doesn’t do very much when interest rates are very low. Perhaps the premium of corporate bond rates over government rates diverges when rates get low. Maybe interest on bank reserves changes the equation. Or maybe the institutional peculiarities of the banking system prevent low rates, quantitative easing and forward guidance from having much of an effect. Perhaps Fed policy affects expectations in ways that are very hard for us to understand, that end up canceling out much of monetary policy’s intended effect.

But whatever’s going on, I don’t foresee the conventional wisdom, or the instincts of central bankers, changing very much. I predict that policy makers, and mainstream macroeconomics, will continue to believe that low interest rates encourage both inflation and growth, and that high rates do the opposite.

The reason for my prediction, frankly, is politics. Macroeconomics has a political spectrum all its own, which is at most loosely connected to the familiar left-right axis. On one side of macroeconomic politics are the true Keynesians, who believe that government spending is the answer to downturns, and possibly can even boost growth in normal times. On the other side are the liquidationists, who believe that recessions are the healthy functioning of a normal economy, and should be left alone, or used to make a political push for structural reforms.

These two sides have battled it out since the Great Depression. The evidence in macro isn't very strong, so it’s been very hard for either side to defeat the other with facts. Instead, what tends to happen is that they fight each other to a standstill. In the end, they agree on the compromise position, which is that monetary policy, rather than fiscal policy or structural reform, should be the main tool of recession-fighting.

Monetarism -- broadly defined as the idea that monetary policy influences inflation and output in the standard, textbook way -- is at the core of mainstream New Keynesian models, and still dominates central bank thinking. There’s evidence for it, and there’s evidence against it, but in the end, I think its prominence endures because it represents a compromise between the Keynesian interventionists and the opposing coalition of anti-interventionists. It posits that technocratic central bankers, manipulating a single price in the economy (the interest rate), are all we need. This is a minimal intervention that liquidationists can stomach and that Keynesians can grudgingly accept.

So I think this is why, despite monetary policy’s limited effects since the Great Recession, macroeconomists and central bankers are still unwilling to consider ideas like Neo-Fisherism that don’t fall along the conventional political axis. Of course, there’s more going on here than this political battle, but I think that the need for an acceptable compromise is what  keeps our thinking on monetary policy frozen in amber.

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

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