St. Louis Fed is seeing the Fisher Effect

The Federal Reserve Bank of St. Louis published an article that low nominal interest rates lead to low inflation… In essence they describe the Fisher effect about which I have been writing here on Angry Bear. There are many economists who do not accept the Fisher effect that low nominal interests lead to stable low inflation. These include Mark Thoma, Nick Rowe, Paul Krugman and David Beckworth.

What did the St. Louis Fed say in their article…

“Assistant Vice President and Economist Yi Wen and Research Associate Maria Arias, both of the Federal Reserve Bank of St. Louis, explain that, in a liquidity trap, investors choose to hoard the additional money resulting from an increase in the money supply rather than spend it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. If this increase in money demand is proportional to the increase in the money supply, inflation will instead remain stable. If money demand increases more than proportionally to the increase in money supply, the price level falls.

In a paper last year, Wen argued that large-scale asset purchases by the Fed at the current pace could reduce the real interest rate by 2 percentage points, but would also put severe downward pressure on the inflation rate, among other effects. In The Regional Economist article, the authors argue that low inflation makes cash more attractive to investors, in turn making a liquidity trap easier to occur.

Wen and Arias wrote, “Therefore, the correct monetary policy during a liquidity trap is not to further increase the money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. … Only when financial assets become more attractive than cash can the aggregate price level increase.”

Evidence and logic is growing for the Fisher effect.