Higher interest rates to tackle inflation

John H Cochrane - On Interest rates as a fiscal policy

A few days ago I gave a short talk on the subject. I was partly inspired by a little comment made at a seminar, roughly "of course we all know that if prices are sticky, higher nominal rates raise higher real rates, that lowers aggregate demand and lowers inflation." Maybe we "know" that, but it's not as readily present in our models as we think. This also crystallizes some work in the ongoing "Expectations and the neutrality of interest rates" project.

The equations are the utterly standard new-Keynesian model. The last equation tracks the evolution of the real value of the debt, which is usually in the footnotes of that model.

OK, top right, the standard result. There is a positive but temporary shock to the monetary policy rule, u. Interest rates go up and then slowly revert. Inflation goes down. Hooray. (Output also goes down, as the Phillips Curve insists.)

The next graph should give you pause on just how you interpreted the first one. What if the interest rate goes up persistently? Inflation rises, suddenly and completely matching the rise in interest rate! Yet prices are quite sticky -- k = 0.1 here. Here I drove the persistence all the way to 1, but that's not crucial. With any persistence above 0.75, higher interest rates give rise to higher inflation.

What's going on? Prices are sticky, but inflation is not sticky. In the Calvo model only a few firms can change price in any instant, but they change by a large amount, so the rate of inflation can jump up instantly just as it does. I think a lot of intuition wants inflation to be sticky, so that inflation can slowly pick up after a shock. That's how it seems to work in the world, but sticky prices do not deliver that result. Hence, the real interest rate doesn't change at all in response to this persistent rise in nominal interest rates. Now maybe inflation is sticky, costs apply to the derivative not the level, but absolutely none of the immense literature on price stickiness considers that possibility or how in the world it might be true, at least as far as I know. Let me know if I'm wrong. At a minimum, I hope I have started to undermine your faith that we all have easy textbook models in which higher interest rates reliably lower inflation.

(Yes, the shock is negative. Look at the Taylor rule. This happens a lot in these models, another reason you might worry. The shock can go in a different direction from observed interest rates.)

Panel 3 lowers the persistence of the shock to a cleverly chosen 0.75. Now (with sigma=1, kappa=0.1, phi= 1.2), inflation now moves with no change in interest rate at all. The Fed merely announces the shock and inflation jumps all on its own. I call this "equilibrium selection policy" or "open mouth policy." You can regard this as a feature or a bug. If you believe this model, the Fed can move inflation just by making speeches! You can regard this as powerful "forward guidance." Or you can regard it as nuts. In any case, if you thought that the Fed's mechanism for lowering inflation is to raise nominal interest rates, inflation is sticky, real rates rise, output falls and inflation falls, well here is another case in which the standard model says something else entirely.

Panel 4 is of course my main hobby horse these days. I tee up the question in Panel 1 with the red line. In that panel, the nominal interest are is higher than the expected inflation rate. The real interest rate is positive. The costs of servicing the debt have risen. That's a serious effect nowadays. With 100% debt/GDP each 1% higher real rate is 1% of GDP more deficit, $250 billion dollars per year. Somebody has to pay that sooner or later. This "monetary policy" comes with a fiscal tightening. You'll see that in the footnotes of good new-Keynesian models: lump sum taxes come along to pay higher interest costs on the debt.

Now imagine Jay Powell comes knocking to Congress in the middle of a knock-down drag-out fight over spending and the debt limit, and says "oh, we're going to raise rates 4 percentage points. We need you to raise taxes or cut spending by $1 trillion to pay those extra interest costs on the debt." A laugh might be the polite answer.

So, in the last graph, I ask, what happens if the Fed raises interest rates and fiscal policy refuses to raise taxes or cut spending? In the new-Keynesian model there is not a 1-1 mapping between the shock (u) process and interest rates. Many different u produce the same i. So, I ask the model, "choose a u process that produces exactly the same interest rate as in the top left panel, but needs no additional fiscal surpluses." Declines in interest costs of the debt (inflation above interest rates) and devaluation of debt by period 1 inflation must match rises in interest costs on the debt (inflation below interest rates). The bottom right panel gives the answer to this question.

Review: Same interest rate, no fiscal help? Inflation rises. In this very standard new-Keynesian model, higher interest rates without a concurrent fiscal tightening raise inflation, immediately and persistently.

Fans will know of the long-term debt extension that solves this problem, and I've plugged that solution before (see the "Expectations" paper above).

The point today: The statement that we have easy simple well understood textbook models, that capture the standard intuition -- higher nominal rates with sticky prices mean higher real rates, those lower output and lower inflation -- is simply not true. The standard model behaves very differently than you think it does. It's amazing how after 30 years of playing with these simple equations, verbal intuition and the equations remain so far apart.

The last two bullet points emphasize two other aspects of the intuition vs model separation. Notice that even in the top left graph, higher interest rates (and lower output) come with rising inflation. At best the higher rate causes a sudden jump down in inflation -- prices, not inflation, are sticky even in the top left graph -- but then inflation steadily rises. Not even in the top left graph do higher rates send future inflation lower than current inflation. Widespread intuition goes the other way.

In all this theorizing, the Phillips Curve strikes me as the weak link. The Fed and common intuition make the Phillips Curve causal: higher rates cause lower output cause lower inflation. The original Phillips Curve was just a correlation, and Lucas 1972 thought of causality the other way: higher inflation fools people temporarily to producing more.

Here is the Phillips curve (unemployment x axis, inflation y axis) from 2012 through last month. The dots on the lower branch are the pre-covid curve, "flat" as common wisdom proclaimed. Inflation was still 2% with unemployment 3.5% on the eve of the pandemic. The upper branch is the more recent experience.

I think this plot makes some sense of the Fed's colossal failure to see inflation coming, or to perceive it once the dragon was inside the outer wall and breathing fire at the inner gate. If you believe in a Phillips Curve, causal from unemployment (or "labor market conditions") to inflation, and you last saw 3.5% unemployment with 2% inflation in February 2021, the 6% unemployment of March 2021 is going to make you totally ignore any inflation blips that come along. Surely, until we get well past 3.5% unemployment again, there's nothing to worry about. Well, that was wrong. The curve "shifted" if there is a curve at all.

But what to put in its place? Good question.

Update:

Lots of commenters and correspondents want other Phillips Curves. I've been influenced by a number of papers, especially "New Pricing Models, Same Old Phillips Curves?" by Adrien Auclert, Rodolfo Rigato, Matthew Rognlie, and Ludwig Straub, and "Price Rigidity: Microeconomic Evidence and Macroeconomic Implications" by Emi Nakamura and Jón Steinsson, that lots of different micro foundations all end up looking about the same. Both are great papers. Adding lags seems easy, but it's not that simple unless you overturn the forward looking eigenvalues of the system; "Expectations and the neutrality of interest rates" goes on in that way. Adding a lag without changing the system eigenvalue doesn't work. John H. Cochrane at 5:17 PM

RBI MPC Minutes

Resolution passed on the meeting

keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 4.0 per cent.

The reverse repo rate under the LAF remains unchanged at 3.35 per cent and the marginal standing facility (MSF) rate and the Bank Rate at 4.25 per cent.

The MPC also decided to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward. These decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth.

Global Economy

Since the MPC’s meeting during August 4-6, 2021, the momentum of the global recovery has ebbed across geographies with the rapid spread of the delta variant of COVID-19, including in some countries with relatively high vaccination rates. After sliding to a seven-month low in August, the global purchasing managers’ index (PMI) rose marginally in September. World merchandise trade volumes remained resilient in Q2:2021, but more recently there has been a loss of momentum with the persistence of supply and logistics bottlenecks.

Commodity prices remain elevated, and consequently, inflationary pressures have accentuated in most advanced economies (AEs) and emerging market economies (EMEs), prompting monetary tightening by a few central banks in the former group and several in the latter. Change in monetary policy stances, in conjunction with a likely tapering of bond purchases in major advanced economies later this year, is beginning to strain the international financial markets with a sharp rise in bond yields in major AEs and EMEs after remaining range-bound in August. The US dollar has strengthened sharply, while the EME currencies have weakened since early-September with capital outflows in recent weeks.

Domestic Economy

On the domestic front, real gross domestic product (GDP) expanded by 20.1 per cent year-on-year (y-o-y) during Q1:2021-22 on a large favourable base; however, its momentum was dragged down by the second wave of the pandemic. The level of real GDP in Q1:2021-22 was 9.2 per cent below its pre-pandemic level two years ago. On the demand side, almost all the constituents of GDP posted robust y-o-y growth. On the supply side, real gross value added (GVA) increased by 18.8 per cent y-o-y during Q1:2021-22.

The rebound in economic activity gained traction in August-September, facilitated by the ebbing of infections, easing of restrictions and a sharp pick-up in the pace of vaccination. The south-west monsoon, after a lull in August, picked up in September, narrowing the deficit in the cumulative seasonal rainfall to 0.7 per cent below the long period average and kharif sowing exceeded the previous year’s level. Record kharif foodgrains production of 150.5 million tonnes as per the first advance estimates augurs well for the overall agricultural sector. By end-September, reservoir levels at 80 per cent of the full reservoir level were above the decadal average, which is expected to boost rabi production prospects.

After a prolonged slowdown, industrial production posted a high y-o-y growth for the fifth consecutive month in July. The manufacturing PMI at 53.7 in September remained in positive territory. Services activity gained ground with support from the pent-up demand for contact-intensive activities. The services PMI continued in expansion zone in September at 55.2, although some sub-components moderated. High-frequency indicators for August-September – railway freight traffic; cement production; electricity demand; port cargo; e-way bills; GST and toll collections – suggest progress in the normalisation of economic activity relative to pre-pandemic levels; however, indicators such as domestic air traffic, two-wheeler sales and steel consumption continue to lag. Non-oil export growth remained strong on buoyant external demand.

Headline CPI inflation at 5.3 per cent in August softened for the second consecutive month, declining by one percentage point from the recent peak in May-June 2021. This was primarily driven by an easing in food inflation. Fuel inflation edged up to a new high in August. Core inflation, i.e. inflation excluding food and fuel, remained elevated and sticky at 5.8 per cent in July-August 2021.

System liquidity remained in large surplus in August-September, with daily absorptions rising from an average of ₹7.7 lakh crore in July-August to ₹9.0 lakh crore during September and ₹9.5 lakh crore during October (up to October 6) through the fixed rate reverse repo, the 14-day variable rate reverse repo (VRRR) and fine-tuning operations under the liquidity adjustment facility (LAF). Auctions of ₹1.2 lakh crore under the secondary market government securities acquisition programme (G-SAP 2.0) during Q2:2021-22 provided liquidity across the term structure. As on October 1, 2021, reserve money (adjusted for the first-round impact of the change in the cash reserve ratio) expanded by 8.3 per cent (y-o-y); money supply (M3) and bank credit grew by 9.3 per cent and 6.7 per cent, respectively, as on September 24, 2021. India’s foreign exchange reserves increased by US$ 60.5 billion in 2021-22 (up to October 1) to US$ 637.5 billion, partly reflecting the allocation of special drawing rights (SDRs), and were close to 14 months of projected imports for 2021-22.

Outlook

Going forward, the inflation trajectory is set to edge down during Q3:2021-22, drawing comfort from the recent catch-up in kharif sowing and likely record production. Along with adequate buffer stock of foodgrains, these factors should help to keep cereal prices range bound. Vegetable prices, a major source of inflation volatility, have remained contained in the year so far and are likely to remain soft, assuming no disruption due to unseasonal rains. Supply side interventions by the Government in the case of pulses and edible oils are helping to bridge the demand supply gap; the situation is expected to improve with kharif harvest arrivals. The resurgence of edible oils prices in the recent period, however, is a cause of concern. On the other hand, pressures persist from crude oil prices which remain volatile over uncertainties on the global supply and demand conditions. Domestic pump prices remain at very high levels. Rising metals and energy prices, acute shortage of key industrial components and high logistics costs are adding to input cost pressures. Weak demand conditions, however, are tempering the pass-through to output prices. The CPI headline momentum is moderating with the easing of food prices which, combined with favourable base effects, could bring about a substantial softening in inflation in the near-term. Taking into consideration all these factors, CPI inflation is projected at 5.3 per cent for 2021-22; 5.1 per cent in Q2, 4.5 per cent in Q3; 5.8 per cent in Q4 of 2021-22, with risks broadly balanced. CPI inflation for Q1:2022-23 is projected at 5.2 per cent (Chart 1).

Domestic economic activity is gaining traction with the ebbing of the second wave. Going forward, rural demand is likely to maintain its buoyancy, given the above normal kharif sowing while rabi prospects are bright. The substantial acceleration in the pace of vaccination, the sustained lowering of new infections and the coming festival season should support a rebound in the pent-up demand for contact intensive services, strengthen the demand for non-contact intensive services, and bolster urban demand. Monetary and financial conditions remain easy and supportive of growth. Capacity utilisation is improving, while the business outlook and consumer confidence are reviving. The broad-based reforms by the government focusing on infrastructure development, asset monetisation, taxation, telecom sector and banking sector should boost investor confidence, enhance capacity expansion and facilitate crowding in of private investment. The production-linked incentive (PLI) scheme augurs well for domestic manufacturing and exports. Global semiconductor shortages, elevated commodity prices and input costs, and potential global financial market volatility are key downside risks to domestic growth prospects, along with uncertainty around the future COVID-19 trajectory. Taking all these factors into consideration, projection for real GDP growth is retained at 9.5 per cent in 2021-22 consisting of 7.9 per cent in Q2; 6.8 per cent in Q3; and 6.1 per cent in Q4 of 2021-22. Real GDP growth for Q1:2022-23 is projected at 17.2 per cent