The irrefutability of neo-fisherism
Matthew Martin 4/17/2015 07:40:00 AM
The neo-fisherite hypothesis is one of the alternative macroeconomic models to emerge after the Great Recession, and it holds that the conventional Taylor Rule is exactly backwards: lowering interest rates actually causes inflation to fall and raising the interest rate causes inflation to rise. John Cochrane has a nice exploration of the idea here. The idea itself isn't new--it has been in the back of macroeconomists' minds since the early days, though I'd credit Noah Smith with giving the hypothesis it's name. The difference between neo-fisherism and orthodoxy is surprisingly subtle--they rely on the exact same equations, and differ only in one particular assumption about the direction of causality. In the neo-fisherite view, causality runs directly from interest rates to inflation so that setting interest rates is the same as setting the inflation rate, whereas in the orthodox view interest rates have only an indirect effect on inflation through monetary operations, while direct causality runs from inflation to interest rates as central banks react to changes in the economy. The difference is so subtle that many macroeconomists aren't even aware they are making these assumptions--a problem worsened by the unfortunate habit of New Keynesians to leave the money market implicit (a topic for another post, but point is there are two equations in NK models that short-circuit the money market, but the model is equivalent to a money-in-utility type model where the central bank uses Open Market Operations to set interest rates).
So the two models differ only by the assumption of the direction of causality between inflation and policy interest rates. And the policy implications of each are exact opposites. How will we know which is right? Reverse-causality is a classic empirical trap.
Here's the dilemma. Let's compare the New Keynesian and Neo-Fisherite predictions right now.
- New Keynesian prediction:
As the economy improves and inflation picks up, the Fed will raise interest rates
- Neo-Fisherite prediction:
as the Fed raises interest rates, the economy will improve and inflation will pick up