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.