Debate renewed for us Neo-Fisherites


Noah Smith opened the debate again on the Neo-Fisherite movement… What is the movement of which I partake as a Neo-Fisherite? When nominal rates are stuck, then changes in inflation will be compensated for by an equal and opposite change in the real rate. The equation is simple…

constant nominal rate = real rate + inflation rate

With a constant on the left side, if inflation falls, the real rate will rise.

Let’s break it down to a simple model where the nominal rate is stuck for a long long time…

fisher 4

If inflation falls, the real rate will rise. If inflation rises, the real rate will fall.

The current hope is that accommodative policy will produce rising inflation driving real rates lower. Even the idea of raising the inflation target is to drive real rates lower.

But inflation depends on economic forces. We now have a world with weak effective demand that is pushing down inflation.

“There has been a long-term downward trend in the share and strength of labour in national income, depressing both demand and inflation.” (link to Vox article)

Can inflation expectations supersede this real effect of lower labor share? No… You cannot squeeze water from a rock. People simply do not have the purchasing power to encourage higher prices. Globally there is a disinflationary environment. Thus inflation is falling, and real rates are rising.

If there was an inflationary environment like in Germany after WWI re-building a country, then you would see more lending to generate inflation. Then real rates would be expected to keep falling and borrowing would pick up even more. But we are in a disinflationary environment with high private debt levels and low labor income.

What is the mechanism?

I love to hear people ask for a mechanism behind the Fisher effect. You do not need a mechanism. If nominal rates are stuck in an environment of disinflation, real rates just rise.

What if nominal rates are raised?

This is the relevant question? If nominal rates are raised, will inflation rise or will real rates rise? The answer depends on whether you think there are forces to push the real rate to its natural rate in the long-run or not. I see forces to push the real rate to its natural rate at full employment.

Take for instance that the nominal rate was raised tomorrow to 15%. We would see the real rate rise to 13% only because inflation would still be trending at 2%. A real rate of 13% would crash the economy.  But now keep holding the nominal rate at 15%. How on earth could the economy generate 13% inflation in order for the real rate to return to a natural rate of 2%? Lenders would love to lend at 15% and receive a real rate of 13%. They would make profits far in excess of the natural growth of the economy. But borrowers would be very reluctant to borrow. So they would try to negotiate lower nominal rates. But remember, nominal rates are stuck, sorry.

So productive firms borrow at high rates and then start raising prices. Labor bargains for more wages. Firms continue to raise prices. Labor continues to bargain for more wages. Eventually the funding cost to debtors diminishes. More firms enter the market. The increased inflation increases borrowing. The increased borrowing feeds inflation. Eventually the 15% nominal rate is matched by a 13% inflation rate and an equilibrium natural real rate of 2%.

Less productive firms just cannot tolerate the higher real rate, but that is ok. We want more productive firms anyway.

And low nominal rates?

Are persistently low nominal rates creating low inflation? First, there is already a disinflationary environment. But what happens between borrowers and lenders?

Take for instance nominal rates at the ZLB with an inflation rate of 2% and a natural real rate of 2%. Lenders are not enthusiastic about lending at a real rate of -2% which is below the growth rate of the economy. Lenders lose out. It’s good for borrowers though. Even the government could borrow at low real rates. Lenders would like to negotiate a higher nominal rate, but remember, the nominal rate is stuck, sorry. Lenders would prefer lower inflation to raise the real rate. So how does inflation fall so that the real rate returns to its socially optimal natural rate (I snuck in the “socially optimal”) Lenders do not normally control prices, so why would firms who borrow lower prices at their cost for the benefit of lenders?

Firms do what they can to make profits. Firms would prefer to raise prices. If firms raised prices, then nominal rates would normally rise to offset the inflation generated. Normally real rates rise in this process too to the benefit of lenders. But we are not allowing that here, sorry. So why then do firms lower prices? Well, demand is low from weak real wages, high private debt levels and hesitant lenders. The economy gets weak. Less productive firms are welcomed. The lower inflation encourages the lenders to cough up some more lending. Firms are put into an environment to keep prices low. The real rate then moves toward its natural rate.

So are nominal rates going to rise?

It is ideal for the nominal rate to fall in a recession and then guide the real rate upwards to its natural rate with steady inflation. Yet, nominal rates cannot be raised now. Central banks are waiting too long to raise nominal rates. People are watching wage growth for signs of inflation to lower real rates and allow nominal rates to normalize. But no wage growth yet. Effective demand remains weak. The economic environment remains disinflationary. The real rate will want to rise to its natural level because in the aggregate population growth and productivity growth are still positive.

We will see the real rate progressively making a stronger rise toward its natural rate which looks to be between 1.5% and 1.8%. People were expecting nominal rates to rise over the next couple of years, which allowed mildly low inflation and a negative real rate to continue. But now that nominal rates are not going to rise, inflation will drop further and the real rate will rise more boldly to its natural rate.