I have recently wrote 2 posts on a model for interest rates and inflation based on the Fisher equation…
Nominal rate = real rate + inflation
Here is the model that I will overlay actual data to below… (link to previous post)
The yellow star represents the Long-run natural target for normalized monetary policy at full employment… with a 2% inflation target and 2% natural real rate, which would give a 4% nominal rate. The Fed would like to achieve a 4% nominal Fed rate by full employment, but there is a possibility that they will only reach 3%.
The present location of the US economy is shown by the blue star. The goal would be to move the blue star directly to the yellow star as the economy reaches full employment.
Has the economy taken this direct path in the past? How did the Fed rate move toward its normalized rate at full employment?
Here is data for the 1960’s… (note: Sun symbol marks end of decade data.)
The path is mostly parallel to a constant inflation rate moving toward the Long-run normalized monetary target.
In the 1970’s, there were times of constant inflation moving toward a normalized monetary policy at full employment. There were also times where inflation grew in spite of rising nominal rates. At the end of the decade, the nominal rate, the real rate and inflation were all rising toward full employment.
In the 1980’s, Volcker set the real interest target over 5%, which brought down inflation. The paths were still many times parallel to constant inflation rates.
In the 1990’s, inflation was coming down. Yet, the path of interest rates during the business cycle was still to raise nominal rates and real rates together. There was momentum to overcome the rising real rates.
In the 2000’s until the ZLB, inflation was well-anchored. So the path of rates was direct toward normalized monetary policy at full employment.
We can see then that the suggested path by Paul Krugman of increasing inflation expectations would be very unusual historically.