Bullard goes neo-Fisherian

It's always easy to be a member of the peanut gallery, hurling criticisms at people who are trying to do their jobs- be they chefs, musicians, sportsmen, or policymakers.  Macro Man is aware of this, and while he believes in all of his general criticisms of the Fed and other central banks, he will concede that sometimes a few of his barbs may be a trifle unfair.  On other occasions, however, decorum prevents him from saying what he really thinks, such is the breathtaking absurdity of what is on display.   On those occasions, as the saying goes, the jokes just write themselves. 

The latest example of this comes from the man that we used to call "Hollywood" at Macro Man's old shop, a Fed president who loves the spotlight like no other.   Step forward James Bullard, president of the St. Louis Fed!  The irony is that Mr. Bullard is an intelligent man who likes to explore interesting ideas on the margins of policy-making orthodoxy.  There's clearly a role for someone to push the bounds of conventional wisdom, particularly given the unusual circumstances in which monetary policymakers find themselves these days.

However, given the prominent role that communication and forward guidance play in monetary policy, particularly for the Fed, is it really too much to ask for a little consistency?   Consider the following timeline:

February 24:   Bullard airs concerns over the level of inflation expectations and breakevens, continuing a line of thought that he first articulated in mid-January.  In such circumstances, he deemed it "unwise" to continue normalizing rates.  What made the timing of these comments so unusual is that the research department of his own St. Louis Fed put out a piece that very day highlighting the absurdity of current breakeven pricing. 

March 16:  The Fed delivers an unambiguously dovish policy release, with both the dots and inflation forecasts marked down despite a pronounced rise in spot inflation.

March 18:  Bullard gives a speech in Frankfurt acknowledging a view that the Fed's policy goals have been met and that it would be prudent to put rates up a bit higher.  WTF?  A mere three weeks after moaning about inflation expectations, Bullard has taken a page out of Macro Man's book and is experimenting with neo-Fisherism.

This, for the uninitiated, is the theory that the private sector sets the real interest rate, which is of course the difference between the nominal rate and inflation.  Thus, if we take the real rate as a given, keeping policy rates low actually generates lower levels of expected inflation.

This is what makes Bullard so frustrating.   His presentation is really very interesting, though Macro Man will admit a bias given that his thinking has been in line with the conclusions for some time now.  Still, the timing, just two days after a dovish Fed announcement and just three weeks after his own concerns about inflation expectations, is just a flat out head scratcher.   Bullard gives the impression of being an intellectual magpie, flitting from shiny new ideas to shiny new idea.  That's great from an economics professor or even a market commentator....but less so from a voting monetary policy-maker.

In any event, and somewhat ironically, reader A.R. had emailed Macro Man the day before Bullard's presentation hit the tape inquiring about what appears to be a strong historical neo-Fisherian relationship between inflation and policy rates.  The chart below plots the 1 year change in inflation (ie. the difference between CPI inflation today and that of 12 months ago, as opposed to the change in prices today versus twelve months ago, which itself is CPI inflation) and the 1 year change in Fed funds.  As you can see, the relationship has generally been very strong, though has broken down during periods of ZIRP.

The relationship also appears quite strong in the UK...

Of course, just because these charts show a strong relationship does not mean that there is a strong neo-Fisherian relationship here.  After all, policy rates move in response to perceived shifts in inflation, both current and expected.  Indeed, you could argue that the two lines in the charts above are so correlated because they are responding to the same stimuli, most notably the rate of economic growth relative to trend.

Still, there is something intuitively appealing to the idea that perma-ZIRP sends a signal that encourages a downward shift in inflation expectations.   After all, the if the central bank economic experts are telling you that there is no inflation and that your money no longer earns any interest, why should you expect any inflation moving forwards?

Ultimately, the problem with just about any economic model is that you can demonstrate just about anything if you try hard enough.  After all, it was once "proven" that listening to "When I'm Sixty-Four" makes you younger!  Perhaps that's the root of the frustration that policy critics feel.  ZIRP and negative interest rates are close to, if not within, the event horizon of a monetary black hole, yet many policymakers are behaving as if classical economics will work as normal, when any first year physics student could tell you that things get mighty strange in and around black holes.

If policymakers were a bit more open to alternatives to the same old, same old, we all might be a bit better off.