And for those of you not reading the other economics blogs, there's a bit of an uproar right now about Narayana Kocherlakota, president of the Minnesota Federal Reserve, and his claim that long-term low interest rates will lead to deflation, when surely every schoolboy knows low rates lead to inflation.
I've been trying to work out why Kocherlakota's argument is so intuitively wrong and yet theoretically consistent with standard monetary models. I think I've got it, with a bit of inspiration from Nick, Karl Smith, Andy Harless and Scott Sumner. So here's my contribution to the monetary analogy industry:
You're driving a truck, one of those big articulated lorries with a trailer full of goods and services. There are three main variables which determine the truck's acceleration:
- how much you push the gas pedal (let's call it i for internal combustion engine)
- how much friction there is from the bumps in the road and other sources (r for road quality)
- how steep is the hill you're on (p for, er, steepness)
Now Kocherlakota points out that in this system, if r is constant, a low i implies a low p. That is, if you manage to keep the truck steady without pushing the gas much, you must be on quite a shallow slope. And a higher i implies a higher p: if you need a lot of gas to keep the truck going, the hill must be steeper. Indeed, if i is low enough, p might even be negative (you are running downhill and only friction keeps you from accelerating). This is all true.
But what is not true is that pressing the gas pedal makes the hill steeper!
Instead, when you push the pedal, the system moves out of equilibrium. Your truck accelerates. You may end up on a different road. All sorts of things change.
What I learned from Karl's argument is that - eventually - flooring the gas does increase the steepness of the hill you're on. But only for this tenuous and indirect reason: if you have somehow managed to avoid crashing, the only way you could have kept the truck on the road is by finding a steeper hill to climb.
Translating back into monetary terms - where i is nominal interest rate, r is real interest rate and p is inflation - the only way a permanently low Fed funds rate leads to deflation is first by accelerating activity, then by causing a long-term shift in expectations, and ultimately by completely changing the equilibrium path of the economy. And that only happens if the economy gets back into equilibrium. Rest assured that is not the likely fate of the truck in this analogy.
You may have noticed the truck off-ramps you sometimes see on mountain highways. They're designed to give trucks somewhere to go if their brakes fail - and, of course, they always have a steep upwards incline. Kocherlakota's argument boils down to the following: if a trucker presses hard enough on the gas for long enough, the truck must end up on one of those ramps. While that may be true, it's no argument against using the gas pedal when you need it.