Nick Rowe and I have fairly similar views on what’s right and what’s wrong with Neo-Fisherism. Recall that Neo-Fisherism is the view that shifting to a policy of higher nominal interest rates will lead to higher inflation, especially if the policy persists for an extended period of time.

There’s a grain of truth in this claim, but at the same time the policy implications are trickier than the Neo-Fisherians seem to assume. This reflects the age-old distinction between one time level shifts in the money supply, and permanent shifts in the growth rate of the money supply. A one-time increase in M reduces interest rates, whereas an increase in the money supply growth rate increases inflation, and hence nominal interest rates. But here’s the problem, every permanent increase in the growth rate of money begins with what looks like a one-time increase. And the fact that prices are sticky makes this all even harder to sort out. So how do you identify easy and tight money?

Nick Rowe has a very clever post that beautifully lays out what’s going on here. He uses the money supply, so I thought it would be interesting to translate his claims into exchange rate language, which is the approach I’ve used in analyzing Neo-Fisherism. Here’s Nick:

They key question to ask is this: when the . . . central bank announces an increase in the . . . . interest rate that it pays on . . . money (call it Rm), what does it announce about the growth rate of the stock of . . . money?

[You need to read Nick’s entire post to understand why I added the ellipses.]
Here’s my translation into forex language:

The key question is when the Bank of Japan announces an increase in the foreign exchange value of the yen, what does it announce about changes in the expected future appreciation of the yen in forex markets?

Now let’s go back to Nick’s post:

If the central bank announces that Rm increases by 1%, and at the same time announces that money growth increases by 1%, then we get Neo-Fisherian results. The inflation rate increase by 1%, but the opportunity cost of holding money is unchanged (the increased Rm and increased inflation cancel out), so there is no initial jump up or down in the price level.

But if the central bank announces that Rm increases by 1%, and at the same time announces that money growth will not change, then we get an initial drop in the price level, because the opportunity cost of holding money has fallen so the demand for money has increased, but there is no subsequent change in the inflation rate.

And my translation into forex language:

If the BOJ announces that the spot exchange rate is unchanged, and at the same time announces that the expected depreciation of the yen increases by 1%, then we get Neo-Fisherian results. The inflation rate increase by 1%, but the opportunity cost of holding money is unchanged (the increased Rm and increased inflation cancel out), so there is no initial jump up or down in the price level.

But if the BOJ announces that the yen suddenly appreciates by 1%, and at the same time announces that the future appreciation of the yen does not change, then we get an initial drop in the price level, but there is no subsequent change in the inflation rate.

You might object that prices are sticky and hence PPP does not hold in the short run. But Nick’s example faces the exact same complication:

If we assumed prices are sticky rather than perfectly flexible, that initial drop in the price level would take a few years of deflation to work itself out.

Nick claims that the key mistake made by both New Keynesians and Neo-Fisherians is that they look at interest rates and ignore the money supply:

It’s not enough to ask what happens if the central bank changes the deposit rate of interest. We must also ask what the central bank does with the money supply. And the New Keynesians (Neo-Wicksellians) are to blame by deleting that second question, by deleting money from their model.

It’s very useful to also look at the money supply, but not essential. What is essential is that you look beyond interest rates, to a monetary measure that gives an unambiguous reading on the distinction between level shifts and growth rates shifts. The money supply does this, but so do exchange rates, or the price of gold (in the 1930s).

In one sense Nick’s money supply approach is superior to my forex approach. It’s more general in that it applies to both closed and open economies. Obviously the exchange rate approach only applies to open economies. But there are an almost infinite number of similar ways of measuring the “price of money”, which do apply to closed economy models. Thus you could replace the spot exchange rate with the one-year forward NGDP futures price, and the expected appreciation in the exchange rate with the expected depreciation over time in the one-year forward NGDP futures price. That applies equally well to a closed economy model. And I would argue that it is superior to the money supply, as it incorporates the effects of both money supply and money demand shocks.

Here’s Nick on the Great Recession:

What actually happened in the Great Recession? Why wasn’t there a deflationary spiral when central banks were constrained by the ZLB? The answer is simple: the price level (and real output too, if prices are sticky) did not spiral down to zero because central banks did not let the money supply spiral down to zero. In fact, they did the opposite. They did “QE” (aka Open Market Operations). Empirical puzzle solved.

I agree, but I’m not sure this will satisfy Cochrane. He might argue that changes in QE didn’t seem to impact the price level, and hence that QE was ineffective. So price stability remains a mystery.

I’d reply that there was little correlation between the amount of QE and the inflation rate for standard “thermostat” reasons. If policy were effective you’d expect to see no correlation.

Cochrane might reply that this excuse is too clever, and that I’d need evidence.

I’d reply that the evidence is in the asset markets, which responded to news of QE as if it were effective.

And that final point is my principle objection to modern macro (New Keynesian and Neo-Fisherian.) There is too little interest in the response of asset prices to policy shocks, and what that tells us about the structure of the economy. These real time prices tell us a lot, if you only bother to look.