The November CPI is in, and inflation continues to moderate despite interest rates that, while rising, are still below current inflation. The great experiment seems to be working out, at least for now. (Previous post, with links to earlier writing.)
As before, the first great question, which economists really don’t have a consensus answer to, is whether inflation is stable or unstable; whether it takes a period of interest rates above current inflation to bring inflation down, or whether inflation will eventually follow the interest rate.
(Yes, I’ve used this picture several times before, but it’s too much fun not to use again.) In the conventional “adaptive expectations” view, inflation is unstable, like the ball on the seal’s nose, unless the Fed moves interest rates quickly, and inflation will spiral away unless interest rates rise above the current rate of inflation. In the more radical “rational expectations” view, inflation is stable and will eventually go away on its own even if the Fed does nothing. (So long as fiscal policy doesn’t add fuel to the fire. Also, it allows for more dynamics; inflation can go up before coming back, and the long run can take a long time.)
The experiment, like the zero bound era, seems to be coming in on the side of stable.
What about the Fed’s rise in rates? In the models I play with, that will help in the short run, but at the cost of stubborn more entrenched inflation eventually. To recap, here is the response of a simple fiscal theory model to a fiscal shock — deficits that people do not expect to be repaid — when the Fed does nothing (top), and to a monetary policy shock — persistently higher interest rates with no change in fiscal policy — (bottom).
In response to the fiscal shock, we get a drawn out period of inflation. The negative real interest rate (interest rate below inflation) slowly eats away at bondholder’s wealth until they have, in essence, paid for the initial deficit. In response to higher interest rates, with no change in fiscal policy, inflation initially declines, but then eventually follows the interest rate. Remember, it’s a “stable” model, meaning it has that “long run neutrality” in it, as a result of rational expectations.