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.