Do Umbrellas Cause Rain?

In a recent speech Minneapolis Fed President Narayana Kocherlakota argues that low interest rates could ultimately be dangerous in that they could lead to deflation. His argument seems bizarre to me. I’ll go through it piece by piece.

The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation.

OK, so far, so good. This is just the definition of the real return: it’s the return that’s anticipated after accounting for inflation.

Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral.

I’ll agree to that, although I shall subsequently quibble with his definition of “neutral.”

This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Not necessarily true. (The long-run real return on safe short-term investments depends on a lot of things besides what the FOMC does, and we can’t say a priori that it will remain in that range.) But I’ll accept it for the sake of argument.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition.

True, as far as it goes, but in his subsequent statement he’s actually talking about superneutrality – the proposition that the growth rate of the money stock (rather than its absolute size) doesn’t affect real activity – which is not entirely uncontroversial. But let’s grant superneutrality, for the sake of argument.

In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

Here Kocherlakota seems either disingenuous or irrational. It’s true that, in a long run equilibrium where the funds rate remains near zero, it also must be the case that there is negative inflation (provided that money retains any value at all). But how do we get to that long run equilibrium? And would we ever get to that equilibrium?

Suppose that the Fed were to keep the funds rate near zero but people began to be dissatisfied with that rate and began anticipating the 1% to 2% long-run real rate. What would happen? People would stop lending short-term money to the government at the near zero rate and instead start lending money elsewhere – for longer terms and to riskier borrowers. The more this continued, the easier it would get to borrow money. The easier it got to borrow, the more people would buy with the borrowed money, and the higher the prices of those purchases would go. And prices would continue going higher until...when?

Prices would continue going higher until they were so high that they were expected to fall. At that point, there would be expected deflation, and we would be at the long run equilibrium. There would be deflation, but it would necessarily be preceded by rising prices – that is, inflation.

However, there is no reason to expect that we would ever get to that long run equilibrium. Instead, if the Fed kept interest rates too low, we would move toward another long-run equilibrium – which Kocherlakota ignores – where money becomes worthless. In that case, the Fed could continue targeting near zero interest rates, but the rates would be meaningless, since nobody would be willing to sell anything, so there would be no reason to borrow money. Now I doubt we would actually get anywhere near that long-run equilibrium, because I think the Fed would raise interest rates long before money became worthless. But the dynamics of market responses will tend to drive toward the worthless-money equilibrium rather than the deflation equilibrium. Why would people ever start to think prices will fall after they start rising rapidly?

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

OK, that is (almost) pure nonsense. It’s true that a low fed funds rate can exist, in long run equilibrium, only if people expect deflation (or if money is worthless). But the causation goes in the opposite direction. People lend at a low interest rate because they expect deflation. People carry umbrellas because they expect rain. An equilibrium with umbrellas must include a significant possibility of rain, but we don’t say that carrying umbrellas must “lead to” rain. If we take away people’s umbrellas, it will not prevent rain, and if we require people to carry umbrellas, it will not cause rain.

The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

That is pretty much the same nonsense as above, except for one thing: perhaps people believe that the Fed knows more about the likely inflation rate than outside forecasters do. If so, people could interpret the continued low interest rates as a signal that the Fed expects deflation, and the deflation could become a self-fulfilling prophecy. If that’s what Kocherlakota means, then he isn’t insane – but he’s still wrong.

The Fed does have a little more information than the public does. For example, it has a better idea of how its own policies will react in the future. And perhaps it has slightly better forecasts than the public. And maybe it has a little bit of inside information about the economy. People may take Fed policies as a signal of its expectations for future inflation, and may react accordingly, but this effect is likely to be far outweighed by the actions of people who disagree with the Fed – or who find the Fed’s expectations irrelevant to their own projects – and want to take advantage of its low interest rate policy.

What does it mean to say that “the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level”? It means there will be opportunities for real investment that have more attractive expected returns. Even if the Fed’s actions lead people to increase slightly their expectations of falling prices, people will also notice these real investment opportunities and will start investing in those rather than in safe short-term investments. Or they’ll take money and spend it on consumer purchases in anticipation of continued employment. Either way, there will be more purchases made, which will tend to drive up prices, and the deflation prophecy will not fulfill itself.

Ultimately, as people notice the economy improving, they will come to expect rising rather than falling prices, no matter what the Fed does. Ultimately, the effect of having the Fed keep interest rates too low for too long will be inflation, not deflation. Of course, the Fed will notice this and then raise interest rates to slow down the economy and stop the inflation rate from rising further, so it shouldn’t be a big problem.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.