In a previous post, I defended neo-Fisherism. A couple of days ago I wrote a post in which I discussed the importance of monetary semantics. I would like to tie together two of my posts so that I can present a more comprehensive view of my own thinking regarding monetary policy and the New Keynesian model.

My post on neo-Fisherism was intended to provide support for John Cochrane who has argued that the neo-Fisher result is part of the New Keynesian model. Underlying this entire issue, however, is what determines the price level and inflation. In traditional macroeconomics, the quantity theory was always lurking in the background (if not the foreground). Under the quantity theory, the money supply determined the price level. Inflation was always and everywhere a monetary phenomenon.

The New Keynesian model dispenses with money altogether. The initial impulse for doing so was the work of Michael Woodford, who wrote a paper discussing how monetary policy would be conducted in a world without money. The paper (to my knowledge) was not initially an attempt to remove money completely from analysis, but rather to figure out a role for monetary policy once technology had developed to a point in which the monetary base was arbitrarily small. However, it seems that once people realized that it was possible to exclude money completely, this literature sort of took that ball and ran with it. The case for doing so was further bolstered by the fact that money already seemed to lack any empirical relevance.

Of course, there are a few fundamental problems with this literature. First, my own research shows that the empirical analysis that claims money is unimportant is actually the result of the fact that the Federal Reserve publishes monetary aggregates that are not consistent with index number theory, aggregation theory, or economic theory. When one uses Divisia monetary aggregates, the empirical evidence is consistent with standard monetary predictions. This is not unique to my paper. My colleague, Mike Belongia, found similar results when he re-examined empirical evidence using Divisia aggregates.

Second, while Woodford emphasizes in Interest and Prices that a central bank’s interest rate target could be determined by a channel system, in the United States the rate is still determined through open market operations (although now that the Fed is paying interest on reserves, it could conceivably use a channel system). This distinction might not seem to be important, but as I alluded to in my previous post, the federal funds rate is an intermediate target. How the central bank influences the intermediate target is important for the conduct of policy. If the model presumes that the mechanism is different from reality, this is potentially important.

Third, Ed Nelson has argued that the quantity theory is actually lurking in the background of the New Keynesian model and that New Keynesians don’t seem to realize it.

With all that being said, let’s circle back to neo-Fisherism. Suppose that a central bank announced that they were going to target a short term nominal interest rate of zero for seven years. How would they accomplish this?

A good quantity theorist would suggest that there are two ways that they would try to accomplish this. The first way would be to continue to use open market purchases to prevent the interest rate from ever rising. However, open market purchases would be inflationary. Since higher inflation expectations puts upward pressure on nominal interest rates, this sort of policy is unsustainable.

The second way to accomplish the goal of the zero interest rate is to set money growth such that the sum of expected inflation and the real interest rate is equal to zero. In other words, the only sustainable way to commit to an interest rate of zero over the long term is deflation (or low inflation if the real interest rate is negative).

The New Keynesians, however, think that the quantity theory is dead and that we can think about policy without money. And in the New Keynesian model, one can supposedly peg the short term nominal interest rate at zero for a short period of time. Not only is this possible, but it also should lead to an increase in inflation and economic activity. Interestingly, however, as my post on neo-Fisherism demonstrated, this isn’t what happens in their model. According to their model, setting the nominal interest rate at zero leads to a reduction in the rate of inflation. This is so because (1) the nominal interest rate satisfies the Fisher equation, and (2) people have rational expectations. (Michael Woodford has essentially admitted this, but now wants to relax the assumption of rational expectations.)

So why am I bringing all of this up again and why should we care?

Well, it seems that Federal Reserve Bank of St. Louis President Jim Bullard recently gave a talk in which he discussed two competing hypotheses. The first is that lower interest rates should cause higher inflation (the conventional view of New Keynesians and others). The second is that lower interest rates should result in lower inflation. As you can see if you look through his slides, he seems to suggest that the neo-Fisher view is correct since we have a lower interest rate and we have lower inflation.

In my view, however, he has drawn the wrong lesson because he has ignored a third hypothesis. The starting point of his analysis seems to be that the New Keynesian model is the useful framework for analysis and given that this is true, which argument about interest rates is correct, the modified Woodford argument? Or the neo-Fisherites?

However, a third hypothesis is that the New Keynesian model is not the correct model to use for analysis. In the quantity theory view, inflation declines when money growth declines. Thus, if you see lower interest rates, the only way that they are sustainable for long periods of time is if money growth (and therefore inflation) declines as well. Below is a graph of Divisia M4 growth from 2004 to the present. Note that the growth rate seems to have permanently declined.

Also, note the following scatterplot between a 1-month lag in money growth and inflation. If you were to fit a line, you would find that the relationship is positive and statistically significant.

So perhaps money isn’t so useless after all.

To get back to my point from a previous post, it seems that discussions of policy need to take seriously the following. First, the central bank needs to specify its target variable (i.e. a specific numerical value for a variable, such as inflation or nominal GDP). Second, the central bank needs to describe how it is going to adjust its instrument (the monetary base) to hit its target. Third, the central bank needs to specify the transmission mechanism through which this will work. In other words, what intermediate variables will tell the central bank whether or not it is likely to hit its target.

As it currently stands, the short term nominal interest rate is the Federal Reserve’s preferred intermediate variable. Nonetheless, the federal funds rate has been close to zero for six and a half years (!) and yet inflation has not behaved in the way that policy would predict. At what point do we begin to question using this as an intermediate variable?

The idea that low nominal interest rates are associated with low inflation and high nominal interest rates are associated with high inflation is the Fisher equation. Milton Friedman argued this long ago. The New Keynesian model assumes that the Fisher identity holds, but it has no mechanism to explain why. It’s just true in equilibrium and therefore has to happen. Thus, when the nominal interest rate rises and individuals have rational expectations, they just expect more inflation and it happens. Pardon me if I don’t think that sounds like the world we live in. New Keynesians also don’t seem to think that this sounds like the world we live in, but this is their model!

To me, the biggest problem with the New Keynesian model is the lack of any mechanism. Without understanding the mechanisms through which policy works, how can one begin to offer policy advice and determine the likelihood of success? At the very least one should take steps to ensure that the policy mechanisms they think exist are actually in the model.

But the sheer dominance of the New Keynesian model in policy circles also leads to false dichotomies. Jim Bullard is basically asking the question: does the world look like the New Keynesian model says or does it look like the New Keynesians say? Maybe the answer is that it doesn’t look like either alternative.