In a post yesterday, I presented a graph of how inflation moves with changes in the Fed rate. I want to explore the graph further, because at some point the Federal Reserve will start to steadily raise their nominal Fed rate. How might inflation respond when the Fed rate starts to increase?
The orange line represents the short run movement of inflation to changes in the nominal Fed rate. As the Fed rate increases for example, inflation will react by decreasing. The blue line shows the long run equilibrium based on where the Fed rate will be at long run full employment, according to the Fisher effect. The long run Fisher effect is always underlying the short run movements.
The arrows show how inflation will move as the Fed starts to raise their nominal Fed rate. First it will decrease, then it will increase toward its Fisher equilibrium. The initial decrease of inflation worries many economists. So, can we be a little more precise on how inflation might move?
To answer that question, I use a system dynamics model in this video to show a projected path of inflation as the Fed raises the Fed rate by 0.25% per quarter.
The video shows that inflation will tend to stay below the Fed’s 2% inflation target as the Fed rate rises. Eventually, once the Fed rate has reached its target and sits still, then the Fisher effect more visibly moves inflation to its long run equilibrium. For the most part, the Fisher effect is unseen like the undercurrents below the ocean surface.
The long run equilibrium for inflation will depend on the long run projected Fed rate. A higher projected Fed rate at full employment allows the undercurrent of the Fisher effect to pull inflation higher.