Friday, November 13, 2015

FOMC | St. Louis Fed Chief Asks Hawks to Think Harder

James Bullard, President of the St.
Louis Fed, predisposed to raise rates
but wondering if this will actually
increase, not lower, inflation.
The President of the St. Louis Fed, James Bullard, is in line to join Jeffrey Lacker of the Richmond Fed in calling for an increase in the fed funds rate.

The St. Louis Fed has historically been the champion of the monetarist school, which keeps reminding Keynesians and New Keynesians who want to keep stimulating the economy that increasing the money supply will cause inflation.

At one time, zero-lower-bound interest rates were viewed as dangerously inflationary. The fact that inflation has remained low hasn't changed the tune of a hawk like Jeffrey Lacker of the Federal Reserve Bank of Richmond. Six years ago he predicted that the zero-lower-bound approach taken in 2008 would make inflation soar. Now he's been voting for a rate increase at the most recent meetings of the FOMC, warning that inflation will get out of control if the FOMC doesn't raise rates.

However, yesterday Bullard gave some support to the idea that the long period of low interest rates – the "Permazero" – might require a rethinking of monetary policy.  At a Cato conference he said that after seven years, expectations for permanently low interest rates might be baked into the cake.

Bullard says we should pay attention to the ideas of John Cochrane of Chicago's Booth School of Business, who suggests that raising the interest rate target off the zero-lower-bound floor may raise, not lower, inflation. The 94-page paper in which Cochrane lays out his theory and data poses the theory as a question – Do Higher Interest Rates Raise or Lower Inflation? 

Cochrane provides charts showing what happens to inflation under different assumptions. If you disagree with his story, I can hear him say, show me your model.

I note that Cochrane relies on the simple version of the Irving Fisher's equation, using an expected inflation rate added to "real" rate.
Most theories contain the Fisher relation that the nominal interest rate equals the real rate plus expected inflation, it = rt +Etπt+1, so they contain a steady state in which higher interest rates correspond to higher inflation. 
This is a simplification of the actual equation, which is multiplicative (rt Etπt+1). The distinction doesn't doesn't matter for low levels of expected inflation (the "Fisher premium"), but it certainly does for higher ones – far as that may be from our recent inflation numbers.

Bullard does not take the step of opposing a rate increase based on Cochrane's theories. That would put him in the same boat as Paul Krugman, who opposes a rate increase on Keynesian grounds that we still need more demand and higher rates could choke off demand.

After seven years of Zero Interest Rate Policy, the FOMC is getting cabin fever. They are generals who look like they are avoiding a battle. Bullard made clear that his predisposition in December is to vote to raise rates. The FOMC may in December want to give the benefit of any doubt to a rise in rates.

Cochrane has therefore done everyone a favor by providing a reason for inflation hawks to think a little harder... because raising rates just might be inflationary.