The news reports from Jackson Hole are very interesting. Fed officials are grappling with a tough question: what will happen to inflation? Why is there so little inflation now? How will a rate rise affect inflation? How can we trust models of the latter that are so wrong on the former?
Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. (It's often called "new-Keynesian" but I'm trying to avoid that word since its operation and predictions turn out to be diametrically opposed to anything "Keyneisan," as we'll see.)
Here is the model's answer:
|Response of inflation (red) and output (black) to a permanent rise in interest rates (blue).|
The blue line supposes a step function rise in nominal interest rates. The red line plots the response of inflation and the black line plots output. The solid lines plot the answer to the standard question, what if the Fed suddenly and unexpectedly raises rates? But the Fed is not suddenly and unexpectedly doing anything, so the dashed lines plot answers to the much more relevant question: what if the Fed tells us long in advance that the rate rise is coming?
According to this standard model, the answer is clear: Inflation rises throughout the episode, smoothly joining the higher nominal interest rate. Output declines.