Projecting a possible path for Inflation as the Fed rate rises
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.
Edward Lambert,
Here is an interesting paper from Larry Summers in January 1982:
http://www.nber.org/papers/w0836.pdf
Extract from the abstract page in the pdf file:
“This paper critically re-examines theory and evidence on the relation-ship between interest rates and inflation. It concludes that there is no evidence that interest rates respond to inflation in the way that classical or Keynesian theories suggest. For the period 1860-1940, it does not appear that inflationary expectations had any significant impact on rates of inflation in the short or long run. During the post-war period interest rates do appear to be affected by inflation. However,the effect is much smaller than any theory which recognizes tax effects would predict. Further- more, all the power in the inflation interest rate relationship comes from the1965-1971 period. Within the1950’s or 1970’s, the relationship is both statistically and substantively insignificant. ”
What stands out in both these papers and in others which I found, is the admission that the Fisher Effect is not detected before 1940. Why?
Larry Summers comment that “ all the power in the inflation interest rate relationship comes from the1965-1971 period” is especially troubling.
This reinforces my doubts about its use today. I have yet to see a good explanation of the possible cause or causes of the Effect and now I learn that the Effect seems to be ephemeral .
In my opinion if the Fed raises the Fed Funds Rate there will be a recession and we would be more likely to see deflation than inflation. And when that deflation ended we would do well to climb back to where we are today.
You and I have agreed that our main problem is a low labor share. That problem still has not been resolved and a recession is extremely unlikely to improve that situation.
JimH,
From the brief look I had at that paper by Summers, he is talking about nominal interest rates adjusting to inflation. Whereas I am talking about inflation adjusting to nominal rates which are not going to adjust because they are planned to stay stationary.
And we also have to take into consideration the inflation potential within the economy. For example, after a war there is heavy demand for investment and inflation is hard to control. Did you Kocherlakota’s article yesterday? He talked about the high inflation in a boom town.
We now have an economy with weak inflation potential due to lower labor share and other reasons. So it is easier to see the Fisher effect now.
Summer’s paper cited in my last comment was titled “THE NON-ADJUSTMENT OF NOMINAL INTEREST RATES: A STUDY OF THE FISHER EFECT”
This paper also speaks of the Fisher Effect with the same year exclusions:
http://deepblue.lib.umich.edu/bitstream/handle/2027.42/26845/0000405.pdf?sequence=1
Extract from the title page of this paper by Robert B Barsky:
“The Fisher hypothesis, which states that nominal interest rates rise point- for-point with expected inflation, leaving the real rate unaffected, is one of the cornerstones of neoclassical monetary theory. Yet prior to World War II, there is essentially no evidence of the Fisher effect in data from Britain or the United States [see, e.g., Friedman and Schwartz (1976. 1982) and Summers (1983)]. For the period 1860 to 1939. the simple correlation of the U.S. three-month commercial paper rate with the ex post inflation rate over the horizon of the bill is – 0.17. The corresponding correlation for the period 1950 to 1979 is 0.71.“
Summers’ paper says that “This paper critically re-examines theory and evidence on the relation-ship between interest rates and inflation. It concludes that there is no evidence that interest rates respond to inflation in the way that classical or Keynesian theories suggest.”
It appears that either you or they are in error in the way that the Fisher Effect is being defined.
I immediately understood their statement of the Fisher Effect. Whereas your’s mystifies me.
With their interpretation of the Fisher Effect, the underlying enforcement mechanism is that lenders will not loan money at rates which would cause them to lose money when the loan is repaid with inflated dollars. Thus they want to factor in expected inflation and interest rates will rise based on the expected inflation. This may not happen in the real world, but it is logical. I doubt their version of the Fisher Effect since it seems to be fleeting but it is logical.
As I said before the general population has no expectation about future inflation. But they know that they must pay the demanded interest if they want the loan.
I see no underlying enforcement mechanism in the economy for your interpretation that in the long run inflation adjusts to the nominal interest rate.
In a much broader sense, we may have more or less growth in GDP depending on the nominal interest rate but that doesn’t have anything to do with the Fisher Effect.
JimH,
They say… “The Fisher hypothesis, which states that nominal interest rates rise point- for-point with expected inflation…”
That is a very different way to look at the Fisher effect than I am doing. I am saying that nominal rates cannot or will not move. When that happens, inflation then follows nominal rates over time.
They assume nominal rates will change. I assume that they can’t.
Can you see the difference?
Okay, let’s ignore the labeling issue for the moment.
Are you saying that the Fed will pick some interest rate and refuse to change it over the long run? (6 years for just a start If not then how is that interest rate to be kept constant?
And then you believe that inflation will adjust to that interest rate? That inflation will rise or fall to some rate and then be substantially fixed?
The major problem that I see is that inflation is substantially based on consumption or the lack thereof and production or the lack thereof. The volume of consumption is not solely based on credit, especially now that consumers are carrying huge debt loads. (In the aggregate) And what would happen to inflation if personal income were to fall. (In the aggregate) The volume of production is subject to prediction errors which raise or lower inventories and motivate the seller to cut prices or not. So I would expect inflation to vary year to year and occasionally dramatically.
Since 1945 we have had regularly occurring recessions. How could inflation not fall during those recessions? And you would expect the Fed to hold the interest rates fixed even if we went into a recession?
If the price of oil were to double as it did between 1972 and 1974 or to go up by a factor of almost five as it did between 1972 and 1980, how could inflation stay constant? Inflation got completely out of control during those years.
The age of the automobile fleet on the road has been getting older and older every year for over 10 years. I believe the average age is now over 11 years. This can not go on forever, consumers will have to start replacing their cars and trucks. Vehicle manufacturers seem to be running high inventories, probably in anticipation of that wave of buying. How is that influencing inflation now and how will it influence inflation after the wave of buying begins. But perhaps consumers can go on much much longer than the manufacturers think. After all Cuba is still running American cars even though they have to make some of their own parts. Then what will those unsold automobile inventories do to inflation? There will be a correction of some sort.
Our economy has a huge number of variables. More than a few of them influence inflation thru paths other than credit.
I don’t understand how this could ever work in the real world.
JImH,
By the Fed’s own statement, they are keeping the Fed rate low for years. That is how they are stabilizing the rate. Normally they are free to change the rate in response to inflation, but they can’t do that now. Thus inflation is drawn like a magnet to the Fed rate, as long as conditions are right for muted inflation.
You should not use the past as a guide for what is happening now. The dynamics are very different.
Firms and investors are being very careful at the moment, even though it may not seem so. They reach for yield but they are more cautious. The stock market is constantly on the edge of a bear market.
As far as the Fisher effect, it is stronger at times, and weaker at times. Now is one of the times that it is stronger.
Let me think of an analogy for you… Let’s say you are a farmer and you grow soybeans. And you are trying to predict the weather in the future. How would you plan your crops if you thought the weather was going to be more stable with less variation? You would tend to grow more precisely according to that stability. Less chance of embedded inflation potential.
Now how would you plan your crops if you felt there was a possibility of better growing conditions? You might feel that you could get lucky and there will be a market for your extra production. So you might be prone to overplant. You might be prone to embed more inflated production in your plans.
It is the same for investors and borrowers. They see stable rates and adjust their plans accordingly for a balanced market. The result is inflation that tends to the base nominal interest rate.
If the Fed rate was more open-ended, business plans could embed more inflation potential to protect against higher rates.