Revisiting the Intricacies of the Fisher Effect to see Inflation more clearly
Follow-up post here to John Cochrane’s clarification of the Fisher Effect. In his post, Mr. Cochrane pointed out the different ways (with stability or instability) that inflation could change to changes in nominal rates. His post includes a graph that since the Fed rate hit the ZLB, inflation has been stabilizing… something which supports the idea of the Fisher Effect.
Now I went back to revisit a video that I made in May, 2014. This video explains the dynamics that John Cochrane presents by comparing the Fed’s inflation target to an “implied” inflation target at Long-run equilibrium.
LR Natural Implied Inflation target = LR Expected Fed rate – LR Expected natural real rate
When the Fed’s inflation target is different from the Long-run implied inflation target, the path of inflation has many possibilities. It could sky-rocket if the implied inflation target is more than the Fed inflation target and the Fed does not react to control inflation. (This happened in Germany after WWI) Or it could stabilize downward to a Fisher Equilibrium if the LR implied inflation target is below the Fed’s inflation target.
The video at the very end shows the case for what many of us are projecting now… That the Fed rate will not be able rise next year, nor even 2016. What will happen to inflation? This video gives a prediction at around the 11:40 minute point that inflation will decline even further.
I post this video again because it explains what we are seeing in the world.
The Fisher Effect as I understand it begins by describing how to determine how much a lender actually receives from the borrower when inflation is acounted for. It should then describe the rate setting behavior of lenders who have an expectation about what inflation will be and an expecation about what they can and should receive as their real return. Clearly, this is a simplification, since there are also costs associated with servicing the loan and with the risk of default which depend on the type of loan.
If you look at mortgages and bonds, you see that loans with negative real rates are not being originated.
The Fed does not set the rate based on its desired real return. The value of making the loan is not described by the real rate. Why should transactions with the Fed follow the Fisher equation?
oops, should have specifically said “corporate and municipal bonds” rather than just “bonds” in the second paragraph above
The Fed rates form the basis upon which all other rates are measured. There are costs added onto these base rates for length of maturity, risk, etc… So the Fed seeks to establish the best basis for these other rates for the good of the economy.
So why should transactions with the Fed follow the fisher effect? It’s that transactions in the broader economy respond to the Fed rate and still try to balance the natural growth rates of the economy. The Fed rate can only influence inflation. Broader investment will still try to attain a balance with the natural growth rate of the economy in terms of population growth plus productivity growth.
The next recession will show us that productivity growth is higher than many think. There will be pressure to raise the real rate toward a higher natural rate. We would either see a higher Fed rate or lower inflation.
“The Fed rates form the basis upon which all other rates are measured.”
This seems like an overstatement.
Fed rates are set in order to try to influence inflation. Mortgage and corporate bond rates will follow inflation regardless of whether the Fed is successful. During periods when the Fed is successful, you should expect there to be a correlation. During periods when the Fed is unable to drive inflation, you should expection the usual relationship between the Fed rate and mortgage rates to break down. If the Fisher Effect remains applicable to mortgage rates but the correlation between Fed rates and mortgage rates is broken, then you should expect that the Fisher Effect with respect to Fed rates is also broken.
I do not feel that “transactions in the broader economy respond to the Fed rate and still try to balance the natural growth rates of the economy” is clear enough for me to believe that Fed transactions should drive inflation through the Fisher Effect.