John Cochrane… Hero of us Neo-Fisherites

John Cochrane responded to recent blogs about the Fisher Effect instigated by Noah Smith.

The best thing that John Cochrane showed in his post is that there are short-run effects and long-run effects of policy rate changes upon inflation. The Fisher Effect represents the long-run effects. There are nice comments under his post.

“…this is the clearest and most lucid explanation of the Neo-Fisherite position I’ve read.” Ben Jackman

“Really excellent post!” Noah Smith

“I like this post.” Nick Rowe

Granted that I also presented the short-run and long-run effects back in May. But John Cochrane is much more recognized than I am and really has presented a clearer picture. Here is a synopsis of what I wrote back in May. (Link)

“… at some point the Federal Reserve will start to steadily raise their nominal Fed rate. How might inflation respond when the Fed rate starts to increase?

exp ret 3

The orange line represents the short run movement of inflation to changes in the nominal Fed rate. As the Fed rate increases for example, inflation will react by decreasing. The blue line shows the long run equilibrium based on where the Fed rate will be at long run full employment, according to the Fisher effect. The long run Fisher effect is always underlying the short run movements.

The arrows show how inflation will move as the Fed starts to raise their nominal Fed rate. First it will decrease, then it will increase toward its Fisher equilibrium. The initial decrease of inflation worries many economists. So, can we be a little more precise on how inflation might move?

To answer that question, I use a system dynamics model in this video to show a projected path of inflation as the Fed raises the Fed rate by 0.25% per quarter.

The video uses system dynamics to show what John Cochrane wrote about short-run and long-run effects.

But there is a a deeper issue in the Fisher Effect.

Can nominal rates be kept constant throughout the whole business cycle? Normally from recession to peak of a business cycle, nominal rates will rise, and so will the real rate. I wrote about this two days ago. (link) Inflation will tend to be stable around the inflation target. But if nominal rates were constant at say 4%, then the recovery would have to start out with a high inflation rate of maybe 3% in order to start the recovery with low real rates of 1%. Then at full employment, inflation would have had to drop to 2% in order to arrive at a natural real rate of 2%.

From experience, inflation does not move this way through a business cycle. Inflation does not drop during a normal recovery. Firms are not likely to be dropping prices as the economy picks up momentum. So the Fisher Effect would have frictions to keep it from working properly.

However, the ZLB is a different dynamic. Real rates are kept artificially low while there are expectations of raising nominal rates to a normal level by full employment. So there will be mild disinflation below the inflation target just as we are seeing now. However, once people start realizing that nominal rates will not return to a normal natural rate by full employment, I would expect inflation to drop more forcefully in a natural attempt to bring real rates to their natural level. Europe is showing that…

So Great post by John Cochrane… the Neo-Fisherite movement has had a victory with his post.