Woodford vs. the Neo-Fisherians

I was trying to think of a good metaphor for Mike Woodford's role in the macro theory world. Dumbledore? But then I'd have to make someone be Voldemort, and I'm not that big of a jerk. Maybe Ed Witten? But far fewer people know who Witten is than know who Woodford is. I give up. Woodford is Woodford. And right now, at this moment in time, Woodford certainly seems like the most influential person in business-cycle theory. Maybe the most dominant influence since Robert Lucas.

One big challenge to the paradigm Woodford has built - which has won near-universal adoption at central banks - is the Neo-Fisherian idea. This is the idea that holding interest rates low for a very long time will either A) make the economy explode, or B) eventually cause persistently low inflation. Looking at the experience of Japan since 1990, (B) doesn't seem so crazy. John Cochrane explained the Neo-Fisherian idea in an epic blog post back in November, and the idea is supported by a more formal model by Schmitt-Grohe and Uribe. It's a big challenge to the Woodford paradigm because 1) the core of the idea is pretty simple, 2) it seems to fit with recent Japanese and possibly American experience, and 3) it says that central banks working in the Woodford paradigm are achieving the exact opposite of what they intend to achieve.

At the recent NBER Summer Institute, Woodford struck back. Actually that makes it sound too confrontational, since Woodford is the consummate nice guy. What he actually did was to address Cochrane's arguments directly, and give some reasons why he thinks they don't apply.

The question of whether interest rates affect inflation in a Woodfordian way or a Neo-Fisherian way depends on whether people's expectations are infinitely rational. Woodford's new idea - which will certainly be a working paper soon - is that people don't adjust their expectations to infinite order. He essentially puts bounded rationality into macro. He posits a rule by which expectations converge to rational expectations.

So to all you guys who ask "When will behavioral economics have a big impact on macro?" The answer is: Right now. It just did. Behavioral macro is now a reality. (Well, really it was a reality with learning models like Evans and Honkapohja, or even Sargent, but Woodford is using it to think about policy in real time, for big stakes, and his presentation will undoubtedly be influential). 

Anyway, I don't understand everything about the new bounded-rationality Woodford model, but from reading his slides, here's what seems to be happening. A permanent interest rate peg ends up making the economy explode. When the peg begins, people think it's a temporary peg. As it continues, people never quite believe it's permanent, but their estimation of its duration keeps getting longer. This makes expectations of the eventual interest rate (infinitely far in the future) diverge, so the economy basically explodes.

So that's the theory, anyway. It's not clear how well this theory applies to Japan, or to other economies that have had very low interest rates for a while now. It's also not clear how well the macro world will accept a behavioral theory as the workhorse model for monetary policy. I guess we'll see, especially after the paper comes out and people (hopefully) start to fit it to data! In the meantime, expect a response from Cochrane. Should be interesting to watch.


Updates

Cochrane has a brief preliminary response. Here is an excerpt:

This is a particularly important voice, as it seemed to me that standard New-Keynesian models produce the new-Fisherian result. i = r + Epi is a steady state in all models. In old-Keynesian models, it was an unstable steady state, so an interest rate peg leads to explosive inflation or deflation. But in new-Keynesian models, an interest rate peg is the stable/indeterminate case. There are too many equilibria, but if you raise interest rates, inflation always ends up rising to meet the higher interest rate. 

What I can glean from the slides is that Schmidt and Woodford agree: Yes, this is what happens in rational expectations or perfect foresight versions of the new-Keynesian model. But if you add learning mechanisms, it goes away... 

[I]f one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

Actually, I'm not sure that this is what Woodford is saying. It's hard to tell from looking at his slides, but it looks like he's saying that if we restrict ourselves to stable paths, the Neo-Fisherian result holds in a rational expectations equilibrium. But the indeterminacy in rational-expectations New Keynesian models might also allow for explosive paths, of the kind that Cochrane calls "old-Keynesian". In fact, I'm fairly certain this is the case, since the "rational bubble" literature shows that explosive paths for inflation are a fairly general result in rational expectations models. I think what Woodford is saying is that if you even slightly relax the assumption of perfect rational expectations, there's no way to get a stable path with a permanent interest-rate peg.

Also: I removed a paragraph making a comparison between Woodford and Nakamura/Steinsson/McKay. Though the problem is similar in the two cases (one is about forward guidance in the infinite future while the other is about belief in a permanent interest rate peg), the two papers use fundamentally different techniques. So the analogy is not a great one, and wasn't that important to the post anyway.

Also: Nick Rowe has a great simplified explanation of the Woodford model. I'm pretty sure he's right, and this is what's going on. It's really impressive how Nick is able to capture monetary econ in these little simplified models...that's a skill I never learned and don't possess. Also, I agree with Nick that if your model isn't robust to an infinitessimal departure from rational expectations, you should be worried.

Also: Scott Sumner comments. He says the problem is the New Keynesian model itself.

Also: Brad DeLong comments. He hypothesizes that Neo-Fisherianism is basically just a face-saving way for economists who predicted QE-->inflation back in 2011 to admit their worldview was wrong without admitting that Paul Krugman etc. were right.