The Dangerous Logic of the Steady-State Fisher Effect
Noah Smith brought up the issue of the long run Fisher effect. Yet, he wants to see micro-foundation models.
“Specifically, what I’d be interested to see is for someone to find some micro-foundations for the Neo-Fisherite result that don’t depend on fiscal policy reaction functions.”
He found a paper written by Stephanie Schmitt-Grohé and Martín Uribe where they offer a solution to the liquidity trap using the Fisher effect. They conclude…
“Finally, the paper identifies an interest-rate-based strategy for escaping the liquidity trap and restoring full employment. It consists in pegging the nominal interest rate at its intended target level. … Therefore, in the liquidity trap an increase in the nominal interest rate is essentially a signal of higher future inflation. In turn, by its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump.”
What does “pegging the nominal interest rate at its intended target level” mean? The US Fed would peg the Fed rate at 4% or so, which would imply a 2% inflation target with a 2% natural real rate of interest. In my view, the economy would be much healthier if the Fed had started gradually raising the Fed rate two years ago toward a projected steady rate of 4% to 5%. I would expect a Fed rate around 3% now. Eventually the economy incorporates a 2% to 3% inflation potential according to the Fisher effect.
The approach to raising and then pegging the Fed rate must express a projected “steady-state”. In this way, the Fed rate must rise gradually on a steady path to the intended target level where it will be pegged corresponding to full employment. The steady-state then draws the broader economy to it. The ultimate goal is to reach and hopefully maintain a steady-state at full employment. Whether or not capitalism has the nature to maintain a steady-state at full employment is a larger question.
Yet, the logic that raising the Fed rate in the US would lead to higher inflation and full employment seems bizarre and dangerous to most. Raising the Fed rate would throw the US into recession, wouldn’t it? How can we understand the micro-foundational mechanisms for this Fisher effect? Well, it is not a straight-forward endeavor.
They are so many chaotic forces that want to push the Fed nominal rate off of its steady-state path. Those same forces push inflation too. The institutional dynamics within every economy vary greatly. Thus, the long run Fisher effect will manifest in many different and wild ways. Here’s a few micro-foundational factors…
- Price setting… If firms have monopoly pricing, they have the space to lower prices to meet lower demand. Inflation can fall. If prices are competitive, another mechanism would be preferred for lowering prices.
- Investor behavior… Investors may or may not accept that the central bank nominal rate as reflecting the intention of a steady-state.
- Wage increases… Does labor have the power to raise wages or not when the economy gets closer to full employment?
- Lending & Borrowing… If the real rate of interest is much lower than the natural real rate, creditors would prefer low inflation to raise their real rate of return. Debtors would like to raise prices in order to lower their real cost of borrowing. Is there sufficient demand to raise prices? Can demand be generated through wage increases that allow prices to rise and that eventually lower the real cost of borrowing?
Beyond micro-foundations, one would also consider the aggregate structure of the macro-economy. Here’s a few macro factors…
- Bifurcation of monetary expansion… If money expands more among the wealthy than labor, then demand for products will be more constrained giving weaker inflationary pressures. On the other hand, if money expansion is more broadly distributed, inflationary pressures are less constrained.
- War torn… If an economy is coming out of war with much to re-build, there is more demand for lending. There will be inflationary pressures. The natural real rate of growth may be higher too. So low interest rates may simply fuel an inflationary boom. Maybe a generation would have to pass for the Fisher effect to settle into its long term equilibrium, with great volatility of inflation along the way.
- Location of investment… Does the country in question have incentives to invest domestically or overseas?
- Corporate Structure… An economy built upon cooperatives where wealth is shared more evenly will respond differently to the Fisher effect than an economy built on oligopolies.
- Effective demand… Is labor share falling or rising in the aggregate? If labor share is falling, inflationary pressures will be weakened.
All the above factors can interact in innumerable ways. One has to look at each economy on a case by case basis to develop an individual model of how inflation would adjust in the long run to a “steady-state” nominal interest rate and a “steady-state” natural rate of interest.
Ultimately the Fisher effect depends on the level at which an economy expresses a steady-state within a multitude of chaotic forces.
“The steady-state then draws the broader economy to it.”
Correlation doesnt mean causation. Just becuase the nominal rate is higher doesnt mean growth will be drawn higher.
“Ultimately the Fisher effect depends on the level at which an economy expresses a steady-state within a multitude of chaotic forces.”
It seems like the Fisher effect is dependant on the assumption of continual increases in productivity which has been correct looking backwards. Looking ahead this may not be the case though. Without productivity increases you cant get much deflation in prices and if rates are held low due to low growth deflation might not actually prevail. Therefore the inflation rate might exceed the interest rate perpetually.
Environmental, resource, conflict, social costs of stagnant economies might not allow deflation to happen.
A higher interest rate shouldn’t send inflation or growth up. I dont think people form their expectations based on the nominal interest rate.
Imagine the economy wasn’t so credit oriented? The interest rate wouldn’t be very relevant then. Balanced money growth would be.
Dannyb2b,
The Fisher effect seems like magic. It is not magic.
We have been living in a chaotic economy that does not understand a steady-state. It is very hard for people to imagine a mature and balanced economy where the steady-state is real and common.
Living in that kind of economy, you would feel like a fish out of water. Life is very different. The Fisher effect would be common place and obvious.
Yet, a steady-state kind of economy is so foreign to what the world understands as normal.
In reality, the economy that we have is very immature in its dynamics. The Fisher effect gets lost in all the attempts to beat the system and surpass natural steady-state limits. Just imagine an economy that is steady, mature, efficient, honest, cooperative, fair, wealth broadly distributed. I know you would love to live in such an economy. I wish it existed too. The Fisher effect unfolds naturally in such an economy.
That is the difference. The Fisher effect stills holds in the economy we have, but there are immature forces to upset it… forces that do not have social wisdom. So it is hard for us to accept that it exists.
Too bad the world does not have a more mature economy. The ecosystem has been badly injured.
Maybe some day in the future.
I understand what your saying and almost 100% agree but would like to add something.
Maybe the correct way to look at it is this:
The natural rate of interest can only be realized in the long term in a natural system. The current system isn’t natural in that it doesn’t follow the laws of nature like balance. Therefore the natural rate of interest wont be achievable in the current unsustainable system and the economic structure looking forward.
The natural rate of interest would be eventually achieved in this unnatural system,but it would be a messy crazy maturation process. The economy would kick and scream like a defiant little boy wanting freedom to do what it desired. The little boy does not understand social harmony.
This is a pretty esoteric conversation, but a steady-state mentality gives us insight into how the Fisher effect can work easily.
Edward
i hope you pursue this line of thinking
I just dont see how the fisher effect will happen for example if rates are held low in a low growth environment. How will prices deflate sustainably if the costs of doing business are increasing from all the social problems and if resource constraints appear or other negatives?
There seems to be a limit to how much prices can decrease unless productivity constantly increases offsetting any inflationary forces which stem from low growth and all the other things like pollution, conflict etc…
Just did a quick scan but my little pea brain jumped to: Typical economics, assume a multitude of can openers.
As John Hussman has pointed out with respect to the short T-rate, and which by necessity applies to the FF rate (since this is an empirical regularity that is one of the strongest I’ve seen) unless there is a huge reduction in the Fed’s balance sheet there’s no way short or long, as I show on my site rates are going up. The “taper” is merely a reduction of the rate of increase of the Fed’s balance sheet, so we’re not even thinking about it at this point.
Even to think that inflation is a solution to anything at this point demonstrates extreme obtuseness, IMO.
Link to Hussman’s chart: http://www.hussmanfunds.com/wmc/wmc110411.htm
Link to my long-term chart: http://animalspiritspage.blogspot.com/2014/02/when-will-long-rates-rise.html
This just looks like an excuse to do something which would be politically unpopular.
And when we repeat the recession of 1937, the excuse could provide some minimal cover. But this sort of deception chips away at the public trust which is already very low where it concerns bankers.
The Fed should already have been raising rates. There would have been less speculation and probably somewhat less of an increase in inequality.
But events are about to overtake Fed policy and they have no place to go. The WSJ (yesterday) and Bloomberg (today) both have articles on the sorry state of the housing markets. Will this be the gentle push that causes the economy to go into recession. GM’s auto inventory is very high and Ford is reporting a 39% year-over-year drop in first quarter net income. How many more gentle pushes will it take?
We have a fundamental problem and it will require a fundamental solution.
Consumers can not spend what they do not have, and producers will not produce what they can not sell.
US consumers are purchasing goods produced overseas. Force some of that production back to the US and we will be on our way back to a healthy economy.
Or we can continue to flail around, trying first one cute gimmick and then another until a decade or two have passed. And then some bright politician will see the merit of ridding ourselves of the Global Free Trade religion.
Mankind seems doomed to search for the impossible, something for nothing. (In the physical world it is a perpetual motion machine.) Global Free Trade has been just the latest theory promising some utopian advantage.
It took the Russians 70+ years to accept reality and rid themselves of communism.
Here is a breakdown of what I see… I ultimately saying that the nominal rate is getting in the way of inflation.
First, 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 best manifests when the CB rate is sitting and waiting in one position. That creates the dynamic of the LRFE. So inflation would adjust to a low nominal rate to raise the real rate to its natural level.
Second, are there inflationary pressures to counter low inflation? At the moment no… labor income and real wages are weak. Labor share has fallen throughout Europe, the US and even China. Inequality is exploding. Inflation is subdued. Thus, the overall economic condition supports low inflation.
Third, You now have a puzzle. Is the low inflation due to low labor share or a low CB rate? Well, they are working together to lower inflation.
Lower inflation lifts the real rate slowly toward its natural rate where it wants to be as the economy reaches its natural GDP level. I calculate that real GDP’s are returning to their natural levels in 2014. So I see a natural process wanting to raise the real rate.
Firms have the monopoly pricing power to lower their prices which attracts investment in their operations, because investors will get a better real return. Firms have to drop their prices due to weak effective demand anyway. Effective demand is weak from low labor share.
So the dynamic in the market place is for the real rate to want to move higher. This is lowering inflation. So if the nominal rate was to rise, room would be created for inflation to rise so that the real rate could keep rising.
The key to understanding the LRFE is…
The pressure driving low inflation is coming from the real rate, not the nominal rate. The nominal rate is getting in the way of inflation.
The real rate is what drives business activity.
Edward Lambert (re your comment above),
I get your point about the Long Run Fisher Effect, but I can’t bring myself to believe it matters in any significant way.
In my opinion, we have low inflation because we don’t have “too much money seeking to purchase too few goods”.
We could either contrive to get more money into the hands of consumers or we could limit the availability of goods. (Burn the goods on the docks.) Either way, we would be creating higher inflation for its own sake, not for any long term benefit to our economy. Sooner or later the stimulus and the fires would have to be extinguished and nothing would have been changed. No one would have been fooled into reckless spending.
In todays world, the benefit of the inflation statistic is as an indicator of the state of the economy. It is what the inflation stat implies that matters. Artificially manipulating the stat just undermines its accuracy as an indicator. In the long run neither consumers nor producers would be fooled.
As I said in my last comment we have to get back to the fundamentals.
JimH,
I just published a post that gives the solution to low inflation. We must combine a rising labor share with higher central bank rates. Inflation will be given an impetus to rise from a higher labor share, and inflation will be allowed to rise so that the pressure from a rising real rate is not constrained.