What Does Neo-Fisherism Say about Unconventional Monetary Policy?

Thinkstock/kchungtw

Today’s post is the third of a three-part series on Neo-Fisherism as an alternative solution to the low-inflation problem.

Our previous two blog posts discussed how conventional central banking wisdom and Neo-Fisherian ideas differ in terms of managing inflation. Conventional wisdom suggests lowering the nominal interest rate target if a central bank wants inflation to increase, whereas Neo-Fisherism suggests raising the nominal interest rate target.

In an article in The Regional Economist, Vice President and Economist Stephen Williamson noted that a risk of Neo-Fisherian denial is that a central bank may end up in a low-inflation policy trap. How does a central bank typically behave in that situation?

If a central bank follows conventional practice—in particular, if it follows the Taylor principle—this implies that it would respond to falling inflation by lowering the nominal interest rate target. Williamson explained that, because of the Fisher effect (i.e., a positive relationship between the nominal interest rate and inflation), this leads to lower inflation. In turn, this causes further reductions in the nominal interest rate target and further decreases in inflation, and so on.

“Ultimately, the central bank sets a nominal interest rate of zero, and there are no forces that will increase inflation. Effectively, the central bank becomes stuck in a low-inflation policy trap and cannot get out—unless it becomes Neo-Fisherian,” he wrote.

Rather than embracing Neo-Fisherism, Williamson noted that central banks typically turn to unconventional monetary policy when they encounter low inflation and nominal interest rates at the “zero lower bound.” He discussed three forms of unconventional policy:

• Negative interest on reserves: Central banks can pay negative interest on reserves at the central bank, which can push market nominal interest rates below zero. 
• Quantitative easing (QE): Central banks can implement QE, which is the large-scale purchase of long-maturity assets, in an effort to reduce longer-term interest rates. 
• Forward guidance: Central banks can use forward guidance, which typically includes promises that interest rates will stay low in the future, in the hope that this will increase inflation.

“But will any of these unconventional policies actually work to increase the inflation rate? Neo-Fisherism suggests not,” Williamson wrote.

He explained that a negative nominal interest rate would cause inflation to go even lower because of the Fisher effect. Regarding QE, he noted that some theory suggests it either doesn’t work at all or acts to make inflation lower. In terms of forward guidance, he noted that it would only prolong the problem.  

Williamson cited several central banks that have been missing their inflation targets on the low side despite implementing low-interest-rate policies and unconventional policies. But why might this matter? He noted that one possibility is that it may impact central banks’ hard-won credibility if they are unable to consistently hit their inflation target.

“As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds,” Williamson wrote. “And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional monetary policies, which are potentially ineffective and still poorly understood.”

• Regional Economist: Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?
• On the Economy: The Fed, Interest Rates and Monetary Policy
• On the Economy: What Will Inflation Be over the Next Year?