# Expected Real Interest Rates & the Fisher Effect

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.

I don’t understand how you can preciscly describe why we have low inflation, (in this paragraph, “Growth of labor income and real wages is mild…”) and then make the leap to higher interest rates would lead to higher inflation. You’ve solved the problem, and don’t need to bring in interest rates at all.

There are two problems, 1 the fisher effect empircally doesn’t hold, as a forward looking measure. So the r in Fisher’s equation is only useful as a backwards looking metric. 2. In neo-classical models Fisher’s r is the same as the return on capital, but there is no reason to believe this is true in the real world. The whole concept of ONE natural real rate is flawed

Thus there is no reason to beleive that the fischer’s r is stable, and therefore there is no need for inflation to “adjust” to keep the system in equilibrium.

AH,

Some of us are now researching this graph of Japan. It is evidence of the Fisher effect. Here is the link…

http://research.stlouisfed.org/fred2/graph/?g=yDP

Can you see the graph?

You will see that the green line of the real interest rate returned to its natural rate around 1%. And stayed close to there for years.

The question now is whether the new inflation is temporary and the real rate will rise again.

I think your ideas on this subject are too abstract and possibly driven by too much psychology. What are the underlying real world mechanisms here?

“The pressure driving low inflation is coming from the expected real rates, not the low CB nominal rates.”

Are you saying that businesses expect these low real interest rates to continue so they can put off investing in their businesses until some time in the future? Thus inflation remains low? If not then who is not spending and why? In the end, there has to be some mechanism operating in the real world.

“The low and rigid CB nominal rates constrain inflation like a tight lid on a boiling pot.”

Sorry, I don’t understand this at all. What is the underlying mechanism to cause this in the real world? In my world view, inflation happens with increased spending.

Perhaps these ideas would play out as you describe if our economy was not in the shape it is in. Businesses complain all the time but the truth is that they have been finding the finance that they need. It is not 2006-2007 type piles of money but the finance is there for good projects. The major constraint today is the scarcity of well funded customers.

You and I agree completely about the need for labor share to increase. Your Effective Demand Limit explains what I see in the real world.

And I believe that the Fed rate should be raised because this low rate is enabling harmful behavior. (Speculation) The general public has gotten most of any potential benefit that they could get with the low rates. Now they are in debt up to their eyeballs. With the rise of residential mortgage rates, the last benefit for the general public is gone. Now we are getting all the harm and almost none of the benefit. (Except that the interest on the national debt has stayed lower.)

If the Fed rate has to stay low then we need to regulate the hell out of the investor class.

JimH,

I just posted about Japan. You will see that inflation fell. then the real rate rose to its natural level.

Now I would say that inflation fell when labor share fell in Japan.

But then ask yourself, what level did inflation fall to? It fell to the level that satisfied the Fisher Effect.

Now do you see how the two are connected?

Low labor share weakens inflation. Then inflation falls to the level that satisfies the Fisher Effect. Japan shows this.

But if you extend the graph back to 1980 you see that the real rate was negative for about 15 years, so I hardly think this is evidence of a stable r.

I think you are definitly right to point out that inflation, interest rates and growth are not related in the way conventional economics thinks they are, but this “neo-fisher” effect is a step backwards. It’s neo-classical economics at its most absurd.

I read your comment above to AH and took a look at the FRED graph.

I note the positive inflation (purple) started in August 2013 and the real interest rate (green) went negative at the same time. In September inflation was negative again and real interest rates were positive again. Then in October and forward to the end of 2013 inflation was positive and real interest rates were negative.

This positive inflation (purple) happened once before from February to December of 2008. The real interest rate (green) went negative at the same time in February and went back positive in May 2009.

So why are real interest rates going negative? Because the Japanese discount rate is struck at .3% and as inflation goes up the real rate goes down. Not interesting.

In Japan Daily Press of June 2013 Japan’s PM Abe targets income increase in economic growth strategy:

http://japandailypress.com/japans-pm-abe-targets-income-increase-in-economic-growth-strategy-0530055/

Thought you might want to read this:

http://www.washingtonpost.com/wp-dyn/content/article/2009/02/15/AR2009021501961.html

“Martin Schulz, an economist at Fujitsu Research Institute in Tokyo, said that the three main pillars underlying Japan’s emergence from the “lost decade” of the 1990s — favorable exchange rates, overseas investment and demand, and old industry such as steel, cars and chemicals — have crumbled.

“The recovery was unsustainable,” Schulz said. “It was built on a major global bubble, and now basically the economy is paying the price.”

Perhaps you are looking at an increase in labor share in Japan? What if Japanese employers saw the economy tightening (see Martin Schulz above) and tightened the purse strings in December 2008. Then last year at the Prime Minister’s urging they loosened the purse strings again?

Now the question is why did inflation go positive in February 2008.

AH

There are times when the real rate can be manipulated like back in the 80s and times when it cannot be manipulated like when the nominal interest rate is against the zero lower bound. At that point, inflation becomes the flexible variable and the real rate returns to its natural level.

Do you see the difference?

JimH,

I hear you. not interesting… but that is why the real rate went back down. The discount rate is stuck.

There are many reasons why Japan keeps its discount rate at the zero lower bound. They are trying to push the real rate as negative as they can, even when inflation turns into deflation. They have to realize sooner or later that the natural level of real GDP has fallen to a lower level. The consequence is that the utilization of labor and capital will not return to their previous levels. Until they accept this hard truth, they will continue to push the nominal rate against the zero lower bound. It is futile effort. They are simply waiting for inflation to respond as they think it should respond.

Edward Lambert

Do you agree that for the LRFF to hold if a central banks holds rates low with growth unresponsive requires increases in productivity in order for prices to decline? If productivity doesnt increase or goes negative then the LRFF cant happen in this low growth low rate environment.

Historically weve had productivity increases sustainably. But productivity may or may not happen looking forward as economies are more mature or negatives from slow growth, environment, resource shortages, corruption etc create inflationary pressures.

Does the Fisher theorem hold in stagflation?

Not really seeing it, How was Inflation was definitly not constrained by policy in japan in the 80s?

Dannyb2b

I hear what you are thinking with productivity. You are seeing an increase in relative supply. Right?

Yet think of the supply potential coming from China. It is not an increase in domestic supply through increased productivity. But it gets the same effect.

Productivity will increase in the future. It is just constrained by effective demand at the moment.

Does the Fisher effect hold in stagflation? Ask yourself this… is the Fed rate made to sit in one place and act passively to stagflation? Or is Fed rate required to manipulate the inflation rate? Or would it be best for the Fed rate to just sit and wait out the storm?

I want to hear your answer…

AH

Something is wrong with the Fred graph when it goes back to the 70’s. The real rate was actually around 3%. I cannot figure out what is wrong with the Fred. i downloaded the data to my Excel program and graphed the real rate. It comes out right in Excel.

I suggest you download the data, then subtract CPI from the discount rate. The graph of the real rate will come out correct.

Edward Lambert

Will productivity increase in China or elsewhere? Maybe yes maybe no. Maybe we have another 2,5, 20 or 50 years of productivity increases. But what if at some point productivity stops growing or declines due to environment (china comes to mind), resources shortages, overpopulation,conflict, corruption, economic malaise etc…

For the Fisher theorem to hold at low rates productivity must always be positive. If it ever isn’t the theory doesn’t hold.

Even at high interest rates if productivity is in decline the Fisher theorem may not hold.

But the real rate of interest isnt important, its the real rate of growth.

To answer your question I would opt for the lower rate in order to get growth at least in the short term. But the current system is unworkable it needs to be rectified because in the end there is no sustainable policy option with the current mechanisms of policy.

AH

I put a graph of Japan’s real interest rate on the Japan post. What happened to the Fred graph?

Dannyb2b,

The natural real rate should include productivity, labor force growth, real output growth. The natural real rate should coincide with natural real growth. So whatever the natural real rate is, the real interest rate will move toward that natural rate by the Fisher effect, if monetary policy takes a position favorable to the Fisher effect.