Expected Real Interest Rates & the Fisher Effect

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The Fisher effect is defined by Paul Krugman & Robin Wells in their textbook… Economics, 3rd Editon 2013, page 721.

“The expected real interest rate is unaffected by changes in expected future inflation. According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point. The central point is that both lenders and borrowers base their decisions on the expected real interest rate. As a result, a change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.”

They say that expected inflation drives the nominal interest rate. Yet, in the next sentence they state that decisions are based on the expected real interest rate. Are they advocating the Fisher Effect? No, they are just presenting it in their book.

  • Suppose that you do not know where inflation will go in the future. What will you base your lending or borrowing decision upon? The expected real interest rate.
  • Suppose that you think future inflation will stay low because there is low effective demand in the economy. What will you base your lending or borrowing decision upon? Again, the expected real interest rate.

I am sure that Paul Krugman would agree, the expected real rate is what drives business activity the loanable funds market. So what is the expected real interest rate? 1% to 2%.

What is the expected future nominal interest rate in 2017? 2% according to the Federal Reserve. They plan to hold the Fed rate below the normal rate of 4% to keep the economy supported.

Therefore, expected future inflation is 0% to 1%.

Breakdown of Current Situation

Let’s say the real rate at the moment is less than -1.0% and it wants to rise to 1.0%. There is pressure for the real rate to rise according to the Fisher effect. As Krugman and Wells say, decisions for borrowing and lending are based on the expected real interest rate, which is 1% to 2%.

The critical point to understand at the moment is where the pressure is coming from to lower inflation. Is it from expected future inflation, expected nominal rates or from expected real rates? The answer is all of them. Yet considering that expected future nominal rates and expected future real rates are somewhat rigid, then inflation becomes the flexible variable. Inflation is being given the freedom to move. The Fed hopes inflation will go up, but it also has the freedom to go down.

Globally, we have a situation where the central bank (CB) rates are sitting in one position and waiting for inflation to react. The “long run Fisher effect” (LRFE) best manifests when the CB rate is sitting and waiting for inflation to move. Inflation is reacting by moving downward.
Next… Are there inflationary pressures to counter low inflation? At the moment no… Growth of labor income and real wages is mild. Labor share has fallen throughout Europe, the US, Japan and even China. Inequality is growing fast. Housing is subdued. The US dollar is stronger. Firms have monopoly pricing, which gives them room to drop prices in the face of low effective demand. In all, inflationary pressures are subdued. Thus, the overall economic conditions support low inflation.
Thus, you have a puzzle. Is the low inflation due to low effective demand or low central bank rates? Well, they work together to lower inflation.

So the combined dynamics of low effective demand and the LRFE move the real rate higher and inflation lower in the face of low and rigid CB rates.

The Key to Understanding the Solution

The pressure driving low inflation is coming from the expected real rates, not the low CB nominal rates. It is like a pressure cooker. The source of the pressure comes from the heat below, not from the tight lid. The low and rigid CB nominal rates constrain inflation like a tight lid on a boiling pot. If the CB nominal rates were to rise, room would be created for inflation to rise. At the same time, effective demand must rise by raising labor’s share more broadly throughout society. Higher effective demand gives impetus to inflation.

The combination of raising labor share and a higher Fed rate would generate higher inflation.

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