Antonio Fatas poses a very good question. You can lower interest rates, but can you raise inflation?
"But if monetary policy is being successful we expect inflation expectations and growth expectations to increase. Both of these forces should push long-term interest rates higher not lower! Something is fundamentally not working when it comes to monetary policy and it is either the outcome of some forces that the central banks are unable to counteract or"
I stop right there. For me, there are forces that the central banks cannot counteract. And the new model is revealing some preliminary mechanism to show how.
I applied the model to Japan's situation of low inflation and low nominal rates.
- Natural real rate is negative = -0.6%
- Effective labor share = 70%
- Capacity utilization optimized at 5% unemployment
- Adjust exponential equation of core inflation to allow for deflation, i = 0.036 * e(-13*net profit rate) – 1%
Here is the model assuming a 2% inflation target...
Two things to note here...
- The central bank nominal rate (solid red line) stays at the zero lower bound almost up to the natural limit of capacity utilization (vertical green line)
- Core inflation hovers on the edge of deflation the whole time up to the natural limit.
Even by keeping nominal rates low, inflation still stays low. Antonio Fatas talks about forces. Here we see the forces at work.
Now I solve for the inflation target that brings monetary policy into balance with the forces.
Look at the horizontal dashed green line of the inflation target. It now sits at -0.3%. The model shows that a mild target of deflation is the best monetary policy to balance the forces affecting inflation.
Also note that the base central bank nominal rate sits at the zero lower bound all the way to and past the natural effective demand limit. (vertical green line)
The model reflects the situation in Japan. Loose monetary policy cannot counteract the forces that want to go into balance at a mild deflation level.
Keep in mind that the model probably needs some tweaking to get coefficients right, but the model can explain forces that Antonio Fatas mentions.
The success of Abenomics depends upon raising labor share. A higher labor share would raise the balanced inflation target. I and others have said this from the beginning. This model gives a logic behind the view..