Uptick in inflation is consistent with Fisher Effect

I read an article by Gavyn Davies, Another False Alarm on US Inflation?. He states that projections of rising inflation are not warranted due to lack of wage-growth pressures. I agree with him, but I want to go one step further and say that the uptick in inflation is understandable.

I have written before about why inflation is low with low nominal interest rates. The reason is the Fisher Effect that says over time, inflation will adjust to a stable nominal rate and a natural real interest rate that is independent of monetary policy.

Inflation = Nominal rate – natural real rate

So if people expect a 3% nominal rate at a far-off full employment and the natural real rate at full employment is 2%, we would see inflation move asymptotically to 1% over time. We also need to see a central bank base rate locked into a specific range for a long time. If the CB base rate starts moving, there are short term reactions to inflation that disrupt the Fisher Effect.

Now if people begin to expect a higher nominal rate sooner, or better yet, if nominal rates are seen to be breaking above their specific range that they are perceived to be locked into, inflation will tend to rise. Firms will hedge the higher expected interest rates by raising prices.

This reaction of inflation to rise is typically seen towards the end of the business cycle when real GDP nears its natural level. People normally do not know when the business cycle will reach its natural end, so when the central bank base rates begin to signal that they are breaking out of a low pattern, people will know to expect higher nominal rates. Firms then raise prices in order to hedge the expected interest rate costs.

The signal to start raising rates is not an alarm. Yet one could see it as an alarm that real GDP is reaching its natural level.