September 24, 2016

THE PUPPET DOESN'T PULL THE STRINGS:

Monetarists are out of ideas (Noah Smith, 9/24/16, Live Mint)

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 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 cancelling 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 policymakers, and mainstream macroeconomics, will continue to believe that low interest rates encourage both inflation and growth, and that high rates do the opposite.

Rather, inflation is the cause of higher rates and deflation, while it causes lower rates, actually hides how high real rates are.

Posted by at September 24, 2016 10:01 AM

  

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