Wednesday, November 18, 2009

Who wants 10% inflation and a 0% nominal interest rate?

Kevin Grier claims that both Krugman and Sumner are wrong. Pete Boetke cites him with approval.

Grier asks,
Can the Fed set the real interest rate at whatever value it wants? I don't
think so.

Do you think they could simultaneously credibly commit to say 10% inflation
and successfully hold the nominal interest rate at zero? Me neither.

What about the simultaneous achievement of 5% expected inflation and a zero
nominal interest rate? Doubtful at best.

What does he mean?

I think he means that if the Fed successfully targets inflation at 10% or 5%, then nominal interest rates will be higher than zero.

I know that Sumner would consider getting nominal interest rates above zero a good thing.

(And, as an aside, Sumner favors returning nominal income to the growth path of the great moderation. My estimate of a target consistent with that growth path for the 4th quarter of 2010 would be about $17 trillion. While that may result in higher expected inflation, the point is to raise real output and employment.)

Getting nominal interest rates above zero is a good thing because of the liquidity trap. If higher expected inflation raises nominal interest rates above zero, then market forces can determine levels of real interest rates that clear markets.

If market forces create an excess supply of credit (or saving greater than investment) at a real rate equal to a zero nominal rate minus the expected inflation rate (usually deflation in this scenario), then the zero nominal bound creates a problem.

That problem is corrected if the expected inflation rate is high enough to get the nominal interest rate high enough that the market clearing real interest rate can be reached.

If prices and wages are perfectly flexible, then real expenditure is always equal to productive capacity, then reductions in real output always reflect decreases in productive capacity.

Either the lower price and wage levels impact the natural interest rate (saving and investment, or the supply and demand for credit as you prefer) or else the price level overshoots (or perhaps one should say, undershoots) creating expected inflation and the market clearing real interest rate.

If prices and wages are not perfectly flexible, then real expenditures can be less than productive capacity and there is demand-constrained production. Production is below capacity until the price level is low enough to raise real expenditures back up to productive capacity.

Raising nominal expenditures fixes that problem. Lower market rates should raise nominal expenditures. But at the zero nominal bound, nominal interest rates can't fall. If it is possible to convince people that prices will rise more rapidly eventually, then even at the zero nominal rate, the implication is a lower real rate. There is presumably some expected inflation rate that is consistent with a market clearing real rate and a zero nominal rate, but if the expected inflation rate is higher than that, the nominal rates rise above zero and real rates still clear markets.

Does Grier believe that prices are always at the proper level so that real expenditures equals productive capacity so that current low levels of real output entirely reflect lower productive capacity? He doesn't say.

Does he believe that the current real interest rates clear markets? That is, the price level now must be at a level so that its expected future rate of of change when subtracted from current nominal rates clear markets? He doesn't say.

As far as I can see, he only seems to be arguing that the Fed cannot keep nominal rates at zero and inflation at 10% or 5%.

So? Is there anyone who considers zero nominal interest rates an end in and of itself?

While I see no value of targeting some high level of inflation, getting nominal interest rates up by shifting expectations is what I think needs to happen.

I favor a target for nominal expenditure--final sales of domestic product--at $16 trillion for the 4th quarter of 2010. This is based upon a modified growth path for nominal expenditure, moving from the planned 2% inflation of the Great Moderation to price level stability. A commitment by the Federal Reserve to expand the quantity of money enough to hit that target will almost certainly cause both nominal and real interest rates to increase at the same time real output and employment grow.


  1. It’s unclear when you write that the problem of the zero nominal bound “… is corrected if the expected inflation rate is high enough to get the nominal interest rate high enough that the market clearing real interest rate can be reached.” The point is not to get nominal interest rates high enough but to get real interest low enough.

    Assume a recession creates a situation where the proper short term real is minus 2 per cent while the short term nominal interest rate has hit zero per cent. If the market expects zero inflation, the expected short term real interest rate is zero per cent. Now, if the central bank is able to credibly target 2 per cent annual inflation, and if the short term nominal rate stays at zero per cent, the expected short term real rate falls to minus 2 per cent, i.e. the credit market clears at the proper short term real rate.

    What if the central bank credibly targets 4 per cent inflation? If the nominal interest rate rises to 2 per cent, then the expected real rate remains at minus 2 per cent. However, if the nominal interest rate increases by more than 2 percentage cent, the expected real interest rate is lifted above 2 per cent,

    So, yes, a spike in the nominal interest rate might be a problem, but it’s only a problem if it increases before inflation expectations have lowered the real rate to its proper rate. And should inflation expectations increase beyond 2 per cent, it’s only a problem if rate if the nominal interest rate spikes more than added expected inflation.

  2. Bill, I saw that one too. I think I left a message there saying that you can't target two variables with one policy tool. So I'd target NGDP, and let interests rates be determined endogenously.

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