Two ways to Fish with the Fisher Effect

http://sewbusylizzy.files.wordpress.com/2012/09/fishing-vest.jpg

I wrote some 4 days ago about the Thoma/Williamson debate. I thought Stephen Williamson w0n the debate with his views on the Fisher effect, which basically state that keeping the Fed rate low into the long run will create low inflation. The basic principle underlying this view is that the real rate of interest is invariant with monetary policy in the long run.

There was some criticism that I agreed with Mr. Williamson. Now today Noah Smith wrote about the “the Neo-Fisherites”. I consider myself one of them.

There is confusion about how the central bank’s (CB) nominal interest rate affects inflation. There is a short run and there is long run strategy. Noah Smith is referring to the long run strategy to affect the inflation rate.

You might hear someone refer to Canada where they have targeted a 2% inflation rate over 20 years. And with all the ups and downs of the CB rate in Canada, they certainly have achieved a 2% inflation. They were able to do this because they raised the CB rate to lower inflation, and then lowered the CB rate to raise inflation. But now the Fisher effect is telling us that lowering the CB rate will actually lower inflation. That is contrary to what worked for the central bank in Canada.

The key is to separate the Fisher effect into a short run and a long run.

I will make an analogy to two types of fishing to explain the Fisher effect.

1. Chasing Fish

One could catch fish by finding them and then chasing them through the water.

When the CB nominal interest rate adjusts to short run movements in inflation, monetary policy is chasing fish (inflation). The CB nominal rate seeks to move inflation. This is what the central bank in Canada did for 20 years.

2. Waiting for Fish

One could also catch fish by placing the bait at a particular location and then waiting for the fish to come to the bait.

When the CB interest rate stays steady in a long run period and does not adjust to short run movements in inflation, monetary policy is waiting for the fish (inflation) to come to it. The CB nominal rate baits inflation to come to it. The mechanism for this is found in the “long run” Fisher equation…

nominal interest rate = natural real rate + expected inflation (1)

The natural real rate refers to the natural ability of an economy to grow with productivity, capital accumulation and its labor force. So when the natural real rate is understood to be invariant to monetary policy over the long run, the Fisher equation becomes this…

nominal interest rate ≈ expected inflation (2)

In the long run the real interest rate eventually returns to its natural level. So in the long run expected inflation will be…

expected inflation = nominal interest rate – natural real rate (3)

Inflation will adjust to the steady nominal interest rate and the natural real rate in the long run.

The CB nominal interest rates have been low and steady for years waiting for inflation to rise. But instead, inflation has lowered, and the real rate is rising towards its natural level. The CBs are trying their best to chase inflation by the old method, but they cannot chase inflation because they are constrained by the zero lower bound. They end up waiting for inflation to move. But the real effect is that they are bringing inflation to them by waiting so long… equation (2).

This whole issue of the Fisher effect will be huge. The implication is that the Fed rate will have to rise for inflation to rise. And there will be lots of resistance from progressive economists who do not want to raise the Fed rate because they think it would produce a premature recession.

Get ready for the responses to Noah’s post…

Comments (4) | |