Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Quiet Inflation at the Zero Bound

John H. Cochrane

NBER Macroeconomics Annual, 2018, vol. 32, issue 1, 113 - 226

Abstract: The long period of quiet inflation at near zero interest rates, with large quantitative easing, suggests that core monetary doctrines are wrong. It suggests that inflation can be stable and determinate at the zero bound, and by extension under passive policy including a nominal interest rate peg, and that arbitrary amounts of interest-paying reserves are not inflationary. Of the known alternatives, the New Keynesian model merged with the fiscal theory of the price level is the only simple economic model consistent with this interpretation of the facts.I explore two implications of this conclusion. First, what happens if central banks raise interest rates? Inflation stability implies that higher nominal interest rates will eventually result in higher inflation. But can higher interest rates temporarily reduce inflation? Yes, but only by a novel mechanism that depends crucially on fiscal policy. Second, what are the implications for monetary policy and the urgency to "normalize"? Inflation stability implies that low interest rate monetary policy is, perhaps unintentionally, benign, producing a stable Friedman-optimal quantity of money, that a large interest paying balance sheet can be maintained indefinitely. The fiscal anchoring required by this interpretation of the data responds to discount rates, however, and may not be as strong as it appears.

Date: 2018
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