Test of the Fisher Effect in Europe

As the ECB (European Central Bank) loosens monetary policy even more in the face of falling inflation, we will see a test of the Fisher Effect. The idea is that inflation is low because nominal rates have been low and projected to stay low for a considerable length of time. The actions of the ECB effectively lower nominal rates even more. What will happen to inflation now?

The Fisher Effect says that in the long run, if central bank nominal rates don’t, you will see inflation adjust to steady nominal and the natural real rate which is independent of monetary policy in the long run. So if nominal rates stay low, and the natural real rate stays steady, the lower nominal rates go, the lower inflation will go.

If the Fisher Effect is acting upon inflation, we should eventually see inflation go even lower in Europe as it did in Japan for so long. It is conceivable to see a short term small bounce upward in Europe’s inflation. But then once the nominal rate decrease shock wears off, inflation should drop even more… if the Fisher Effect is real.

Thus we will have a test of the Fisher Effect. We (the Neo-Fisherites) will be watching inflation in Europe.