posted on 14 November 2016
from the St Louis Fed
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 Williamsonnoted 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?
Low-Inflation Policy Trap
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.
Unconventional Monetary Policy
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:
“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."
Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.
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