Next week’s figures are likely to show that consumer price index (CPI) inflation is below its 2 per cent target, which means that a decade of near-zero interest rates has not led to high inflation.
Standard economic theory says this is because without such low rates the economy would have been even weaker than it has been and so inflation would have been lower, very possibly even negative. There is, however, a challenge to this view. Economists such as Stephen Williamson at the University of Western Ontario and John Cochrane at the University of Chicago have suggested that standard economics has got things the wrong way around, and that low interest rates actually cause low inflation rather than vice versa. Tthis view is called neo-Fisherism, after Irving Fisher, a Yale University professor in the early 20th century.
Such a view has some empirical base. For decades, high inflation and high interest rates have gone together, as have low rates and low inflation. And it’s not necessarily the case that it is low inflation that leads to low rates as standard economics says. Back in 1986 Princeton University’s Chris Sims showed that higher interest rates tended to lead to higher inflation, a finding recently corroborated by Columbia University’s Martin Uribe.
Randall Wray at the University of Missouri-Kansas City says: “There is no empirical evidence to support the belief that raising interest rates fights inflation." Most economists don’t go that far: Bank of England researchers have found evidence for the conventional view. But the evidence is sufficiently mixed to provide a so-called 'price puzzle' that economists are still struggling to explain. One possible explanation, though, is simply that Williamson and Cochrane are right.
This raises the question posed by the St Louis Fed’s David Andolfatto: what’s the mechanism whereby higher rates might cause higher inflation, and lower rates lower inflation?
In fact, there are several possibilities. One is that a rise in short-term rates, if sustained, would raise the cost to the government of servicing its debts. This could start people worrying that the government will print money in future to cover the higher deficits caused by that extra spending. This would raise inflation expectations – which would raise actual inflation if people spend more now in anticipation of money losing its value in the future. By this thinking, rate cuts would cut future government spending on debt servicing, thus reducing the fear of future monetisation and so reducing current inflation. This is one version of the fiscal theory of the price level.
Another possibility is that a rate cut would signal that the central bank expects bad times. In anticipation of those bad times, people would cut spending, and companies would cut prices in an effort to clear inventories and raise liquidity as a precaution against tough times.
Yet another possibility is that sustained low rates depress profit margins. They help to keep indebted companies in business, thus intensifying competition. And because they raise the net present value of future cash flow, they encourage companies to cut prices in an effort to expand and win more future business.
Whether these mechanisms are operating now is, however, doubtful. Both the fiscal theory of the price level and the signalling effect imply that lower rates should reduce consumer spending. But, in fact, this has been relatively strong in recent years. And while retailers’ profit margins have recently been under pressure, margins in the economy generally (measured by the share of profits in GDP) have been around their long-term average.
Personally, my view of neo-Fisherism is much like my opinion of the theory of expansionary fiscal contractions. It could be true in some times and places, but I very much doubt that it is true here and now. Nevertheless, it serves the great purpose of forcing conventional economists to think more carefully about ideas they have for years taken for granted.
