The State of the Macro Debate
This post considers whether raising interest rates could raise inflation instead.
Macro has always been a strange field. No one really knows what we’re doing, so we invent buzzwords like “aggregate demand” and econometric tools like GMM which no one actually uses.
A consequence of this strangeness is that it’s relatively acceptable to disagree with the consensus in the field and style yourself as the follower of a “school of thought”. Some of these schools are better integrated within the mainstream, while others are completely neglected in academic circles. Today we’re going to dive into each of these schools and what they tell us about inflation.
The New Keynesians
Also known as mainstream vanilla macro. Really, it doesn’t get any more “consensus” than this. New Keynesian models tell us that inflation is primarily driven by the difference between the “neutral” rate of interest and the actual interest rate. The “neutral” rate being the interest rate which would keep inflation steady.
If we take this model at face value, then the “neutral rate” should consist of two components: inflation expectations and the “natural real rate” (yeah, very useful, I know). If we further assume that the natural real rate is at around 2% (somewhat reasonable) and use the TIPS spread to measure inflation expectations, we’ll get that interest rates of around 4.5-4.75% are “neutral”. So the Fed will have to hike to at least 5% for inflation to start falling.
Does that sound like the exact approach the Fed is taking? Well yeah, probably because New Keynesian macro *is the mainstream*.
The Market Monetarists
Mum look, it’s me! Market monetarists are a weird bunch insofar as they don't have very good ideas for how the Fed should forecast inflation. Instead, they generally say that the Fed should (1) target NGDP (2) target the *level path* of NGDP and (3) target the *forecast* of NGDP.
This basically means that the Fed should keep adjusting its policy until it expects NGDP to go back to trend.
OK, well maybe not *that* trend, since that would require an uncomfortable amount of deflation. But market monetarists basically believe that a level targeting policy would have made the Fed’s target much more credible, which would have made this inflationary episode significantly easier to fight.
In any case, the market monetarist prescription is to look at NGDP as a sign of inflationary woes. This is because NGDP helps you “see through'' supply shocks - i.e. since supply shocks lower RGDP and raise inflation, their effect on NGDP will be smaller. This has also meant that market monetarists see our current inflation as primarily the Fed’s fault, as they think it unlikely that nominal incomes could grow so rapidly if inflation were caused by supply restrictions.
The Old Keynesians
You’d think their ideas would be dead, but nope. Like zombies, they just refuse to stay down. Old Keynesian models refer to the olden days of the naïve Phillips Curve which asserted that inflation was caused by low unemployment and the way to defeat it was to…raise unemployment.
Really, these ideas were supposed to be dead, but a certain macroeconomist who is too smart for his own good continues to invoke them. Oh well.
Speaking of Old Keynesian ideas being dead, I bring to you, their killer.
Old Monetarism
Decades ago, some guy you may have heard of explained that the Phillips Curve was a terrible guide to monetary policy. Over time, people’s expectations would change and it would collapse. Friedman was completely right and this remains one of the greatest out of sample predictions in macroeconomic history.
At the same time, he developed monetarism, which basically states that inflation is caused by the growth of M2, a broad monetary aggregate. Central banks have slowly grown way of this view since the relationship between M2 growth and inflation appears to have collapsed (and so has our confidence in the central bank’s ability to control M2), but “old monetarism” seems to be making a comeback. Part of this is down to Lars Christensen’s eerily accurate inflation prediction from 2021 (who is technically a market monetarist, but uses “old monetarist” reasoning in this post).
Old monetarist thinking basically tells us that we should look to the money supply as a guide to where inflation will head. And if we take this at face value, it looks like we should expect inflation to keep falling (and perhaps even turn negative!)
MMT/Post Keynesian Macro/Other Leftists
Sorry not sorry but I’m lumping all of them in together. The exact beliefs of MMT and PK thinkers is sometimes hard to pin down, but we can probably summarize their thoughts as follows:
The government can prevent inflation by using taxation, therefore, raising taxes (perhaps on the rich?) is the best way to fight inflation.
Nevertheless, our current inflation has different roots and requires different methods.
More specifically, supply shocks have given firms with market power the ability to pass on costs to consumers and increase their markups.
So the way to fight inflation is to impose price controls so that these supply shortages don’t affect the broader price level and firms don’t get away with excess profits.
Interest rate hikes may actually increase inflation because of their effects on supply. Firms will have to lower output and things might get worse.
These views are convenient insofar as they completely sidepass the usual but uncomfortable MMT prescription from (1) of raising taxes. They also have the added benefit of prescribing anti-inflationary policies that PK thinkers support regardless of whether there’s inflation. And of course, there’s point 5.
Neo-Fisherians
Neo-Fisherianism refers to the general belief that raising interest rates can result in higher as opposed to lower inflation. One way to justify this logic is by appealing to the supply impact of interest rates (like Post-Keynesians do), but a more conventional argument would take the following form:
The nominal rate is equal to the real rate + inflation
The Fed, at least in the long term, can’t control the real rate of interest
Therefore, raising the nominal rate will raise inflation in the long term (because the real rate is fixed).
The general monetarist response here would be that the real rate isn’t really fixed and that’s why interest rates can work as a policy tool. A more brutal argument would just say “look at Turkey” which has tried to fight price increases by lowering interest rates and ended up with 85% inflation in October.
In any case, Neo-Fisherians vary from “batshit insane” like Warren Mosler and “at least he has a model” like John Cochrane (who claims that rate hikes lower the price level, but raise long-run inflation).
The Austrians
The darling of internet libertarians. What can I really say here? Austrians (like market monetarists and like self-consistent New Keynesians) believe that central banks are primarily responsible for recessions. Except that in their story, recessions are caused by bubbles bursting, and these bubbles in turn form because central banks lower the interest rate below the “natural” or “neutral” level.
Furthermore, Austrians are bigger monetarists than monetarists themselves and believe that inflation is only really a thing because of central banks. So you won’t be surprised to hear that the average Austrian’s solution to our problems is going to be either abolishing the Fed in favor of some type of free banking system (these are the Hayek types, which sort of intersect with market monetarism because of their belief that free banking can stabilize NGDP) or switching to a gold standard (ugh).
Conclusion
So there you go. That’s a general list of the different takes you’re going to hear about macro and inflation. Really, only the New Keynesians and market monetarists are taken seriously in the mainstream (with the latter being a much smaller minority), but all groups raise *some* interesting questions to consider. Except for the Old Keynesians. Why can’t they just stay dead?