Neo-Fisherism’s attack on the Taylor Rule : Central bankers are potentially the biggest losers!
Neo-Fisherism is both interesting and amazingly counterintuitive at the same time. Whilst Neo-Fisherism has launched an attack on the Taylor Rule applied by central banks globally, the two theories may not be as incompatible as they initially appear. The nuances highlighted by Neo-Fisherism may also throw further light on the limitations inherent in monetary policy.
What is Neo-Fisherism?
At its heart Neo-Fisherism (‘NF’) comes back to the standard relationship established by Irving Fisher that:
R = r + π
R = Nominal interest rates
r = Real interest rates
π = inflation
From this relationship NF contends that higher interest rates will bring about higher inflation. The logic is that r is set by fundamental factors which do not change over the long term and are largely outside the control of policy makers. Accordingly, if a central bank is increasing the long-term interest rate then over time π must increase so the long-term value of r is maintained. The relationship is therefore simply the encoding of a long-term relationship between inflation and nominal interest rates.
NF’s attack on the Taylor Rule
Now this does appear to be counterintuitive as the traditional view encapsulated by the Taylor Rule is that by boosting economic activity, lower interest rates push inflation higher. It would therefore appear that NF and the Taylor Rule are mutually incompatible; i.e. one advocates lower interest rates to raise inflation the other higher interest rates. But first impressions can be misleading as the Taylor Rule also anticipates that in the longer term it will have the same impact as higher inflation will ultimately mean R will be higher. The distinction between the two approaches can easily be dismissed as simply arising from a difference in timeframes; i.e. there isn’t inherent conflict between NF and the Taylor Rule once differences in timeframes are allowed for.
Though there is merit to the timeframe distinction, it does miss the more interesting point highlighted by NF that the Taylor Rule can break down. This highlights that there can be alternative dynamics between interest rates and inflation than those indicated by the Taylor Rule which is one of the key insights from NF.
Inherent limits to the Taylor Rule
The essence of the Taylor Rule lies in the negative relationship between interest rates and inflation. Given this relationship, a central bank will alter interest rates to achieve a predetermined inflation target according to a policy reaction function defined as:
Rt = r0 + β (πt – π*) + ϵt
What results from this formulation is a standard Taylor Rule where β represents the central bank’s policy reaction function to inflation (‘π’) differing from its inflation target (‘π*’). The important factor within the policy reaction function is β which measures the responsiveness of a central bank to deviations away from its inflation target; i.e. the movement in interest rates relative to the change in inflation from target. The traditional formulation of the Taylor Rules requires that β > 1; i.e. there is a greater than ‘one for one’ relationship between interest rates and inflation deviations. Put another way the Taylor Rule explicitly assumes that central banks react aggressively to deviations from their inflation targets. It is the market’s expectation that central banks will react aggressively to contain deviations from their inflation targets which ultimately anchors inflation expectations. It follows that while β > 1 it can be expected to observe normal behaviour, as set out by the Taylor Rule, with inflation expectations remaining anchored around the central bank’s inflation target.
The much bigger issue with respect to the Taylor Rule arises when the central bank is not committed to respond aggressively when inflation is off target; i.e. β < 1. Under such a scenario, inflation expectations have a greater potential to become unanchored from the central bank’s inflation target. The unanchoring of inflation expectations from the central bank’s inflation target now means that rather than a predictable relationship one is faced with a much broader distribution of possible outcomes arising from a change in interest rates; i.e. the Taylor Rule starts to break down. It is this loss of a predictable relationship which creates issues for central banks which are trying to set monetary policy to achieve a pre-set inflation target.
Why is the potential for a breakdown in the Taylor Rule particularly relevant now? This is particularly relevant now when one considers that there is likely to be a negative relationship between β and Rt for a given level of π*. Clearly if Rt is materially greater than π* there is greater scope for β > 1. Conversely if Rt is around, or indeed less than, π* then it is more likely that β < 1. The result is that in low interest rate environments one is more likely, though this is not assured, to generate an NF consistent outcome. What is ultimately occurring is the predictability of the interaction between interest rates and inflation is being reduced as β declines along with the level of interest rates.
The need to coordinate monetary and fiscal policy to increase inflation
At its core the importance of NF is highlighting that under certain conditions the negative relationship assumed between interest rates and inflation will start to break down. Yet even here there is an interesting nuance which is increasingly relevant to the current environment. Faced with scenarios where the interaction between interest rates and inflation is less predictable NF needs an additional influence to create a positive relationship between interest rates and inflation. To generate the required outcome NF relies upon the government adopting a stimulatory stance to fiscal policy at the same time interest rates are increasing. What is interesting in terms of NF is the highlighting of the need to effectively coordinate monetary and fiscal policy in order to achieve an increase in inflation.
NF’s assault on the Taylor Rule, though not discrediting the Taylor Rule, has highlighted some interesting nuances in the entire debate over monetary policy. By doing so it has re-shone the light on the inherent limitations of the Taylor Rule as applied by central banks since the late 1970’s. Namely :
- The Taylor Rule’s predictable negative relationship between interest rates and inflation holds provided interest rates are high enough to facilitate aggressive moves in monetary policy.
- Many central banks have got themselves into a position where interest rates are so low that the conditions required by the Taylor Rule no longer hold or, if they do, hold only weakly.
- The current situation is not the result of central banks not lowering interest rates enough but the result of not being aggressive enough initially; i.e. the gradualist approach to lowering interest rates adopted by many central banks.
- With interest rates being so low the predictability of changes in monetary policy on inflation has declined as inflation expectations have become unanchored from the central bank target.
- Unless undertaken on a scale unseen in the post GFC period even QE by itself may not materially increase inflation.
- Achieving a desired inflation target may require greater coordination of monetary and fiscal policy.
NF has highlighted that the negative relationship between interest rates and inflation, as captured by the Taylor Rule, is not an inevitable outcome. Central banks may find themselves in a ‘low inflation policy trap’ where interest rates are so low that the further lowering of interest rates will prove insufficient to achieve their inflation targets. In such a situation it will increasingly fall upon both fiscal and monetary policy to be coordinated if an economy is going to achieve its desired inflation outcome. Achieving the required level of coordination potentially relegates monetary policy to simply become another arm of government policy. If this is the case, then it makes it harder to justify ongoing central bank independence. Ironically central bank independence may be the biggest loser arising from their own success in exorcising the demons of high inflation from the 1970’s.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...