Does a lowering of a central bank’s interest rates create inflation or deflation? Dubbed the ‘Sign Wars‘ by Nick Rowe, this has been a recurring debate in the economics blogosphere since at least as far back as 2010.
The conventional view of interest rate policy is that if a central bank keeps its interest rate too low, the inflation rate will steadily spiral higher. Imagine a cylinder resting on a flat plane. Tilt the plane in one direction —a motif to explain a change in interest rates—and the cylinder, or the price level, will perpetually roll in the opposite direction, at least until the plane’s tilt (i.e. the interest rate) has been shifted enough in a compensatory way to halt the cylinder’s roll. Without a counter-balancing shift, we get hyperinflation in one direction, or hyperdeflation in the other.
The heretical view, dubbed the Neo-Fisherian view by Noah Smith (and having nothing to do with Irving Fisher), is that in response to a tilt in the plane, the cylinder rolls… but uphill. Specifically, if the interest rate is set too low, the inflation rate will jump either instantaneously or more slowly. But after that, a steady deflation will set in, even without the help of a counter-balancing shift in the interest rate. We get neither hyperinflation nor hyperdeflation. (John Cochrane provides a great introduction to this viewpoint).
Many pixels have already been displayed on this subject, about the only value I can add is to translate a jargon-heavy academic debate into a more finance-friendly way of thinking. Let’s approach the problem as an exercise in security analysis.
…click on the above link to read the rest of the article…
