There is a movement taking place to understand the Fisher Effect. What is the Fisher Effect? Basically the idea is that low and stable nominal interest rates from the central banks leads to low and stable inflation.
I have been writing here on Angry Bear that the Fisher Effect is made stronger when the nominal rates are projected to be stable years into the future. And we are seeing now that central banks are projecting abnormally low nominal rates for years to come.
J. Scott Davis, Adrienne Mack and Mark A. Wynne from the Dallas Fed have presented an important foundation for the Fisher Effect we are seeing. They wrote an article, Central Bank Transparency Anchors Inflation Expectations. In this article they describe how the transparency of central banks have risen over the years. And they also write how inflation expectations have become increasingly anchored over time, not only in the US but other advanced countries. They write…
“Among advanced countries, a review shows a strong relationship between an index of central bank transparency and one measuring the anchoring of inflation expectations.”
How do transparency and a stronger anchoring of inflation expectations make the Fisher Effect stronger?
The Fisher Effect is slippery like a fish. You need to have the right economic conditions for it to appear. Here are 4 conditions.
- Productive capacity in relation to Effective demand. When productive capacity is low and effective demand is high, like after a war, there are forces to generate higher inflation. These forces overpower the Fisher Effect of low nominal rates to keep inflation low. On the other hand, we currently have a situation where productive capacity is high in relation to effective demand. The current situation supports low inflation.
- Past stability of nominal rates. For 5 years, the nominal rates from many central banks have changed very little. Most are stuck at the zero lower bound. Thus, nominal rates have had little impact to actively influence inflation expectations. So inflation expectations have had to react to broader economic conditions, which in themselves are based on a stable nominal rates, high productive capacity and low effective demand.
- Projected stability of nominal rates. When there is more certainty that nominal rates will stay low within a narrow range even in the face of future economic growth, it is safer for firms to embed lower price levels in contracts and business plans. The goal is to maximize returns and profits for investors and firms alike. So they arrive at a balanced relationship. Low nominal rates make it safer for borrowing firms to embed lower prices, because there is less of a need to hedge against possibly rising nominal rates. Likewise, it is safer for lending firms to accept lower price inflation.
- Strongly anchored inflation expectations. When the monetary policy coming from a central bank is more transparent and stable, it is even easier for firms to embed stable inflation expectations. If there was more uncertainty, we would see firms hedging more by embedding the possibility of higher prices just in case nominal rates rose. A greater uncertainty over future nominal rates can lead to greater embedded possibilities of higher inflation.
Now the authors of the Dallas Fed article give evidence for the 4th point to support the Fisher effect. There has been an increasingly greater transparency of monetary policy from central banks. The intent was to create greater credibility. They have achieved that. Yet, at the same time, probably without realizing it, they have created a trap for low inflation alongside their reasoning for low nominal interest rates.
One might assume that the Fisher Effect leads to only one solution for low inflation; That is to just raise nominal rates. However, that solution creates a disinflationary effect in the short term. Well, there is another solution. Central banks could create more uncertainty in their monetary message wthout actually raising nominal rates. The uncertainty can form cracks in the Fisher Effect, which allow for higher embedded inflation hedging in business plans.
Central banks are being too credible, too transparent, too stable with their low nominal rates, too certain, too narrow… They are also being too stubborn in their thinking that ever lower nominal rates will eventually make inflation rise. Their stubbornness may lead to an underlying unstable uncertainty about the future, which could generate uncontrollable effects on inflation.
The best practical solution for low inflation is for central banks to allow the possibility of higher nominal rates in the future and not lock themselves into a narrow range of abnormally low projected nominal rates.