Visualizing the Various Paths of Interest Rates & Inflation

Let’s go beyond the issue of the Fisher Effect and visualize the whole issue of nominal interest rates, real rates and inflation. The Fisher Effect is only a part of the whole issue.

So we start with a model that blends all 3 rates… nominal rates on the y-axis, real rates on the x-axis and each up-sloping line represents a different stable inflation rate…

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The up-sloping line farthest to the left represents a stable inflation of 4%. As nominal rates rise, the real rate will rise too, since…

Real rate = Nominal rate minus inflation rate.

The lines to the right represent decreasing inflation and beyond into deflation.

The vertical dashed line is the Long run socially optimal natural real rate. The economy ideally will be at this vertical line for any nominal rate when it reaches full employment. The yellow star shows where the Federal reserve would like to be at full employment with an inflation target of 2%, a real interest rate equal to the Long run natural real rate of 2% and a nominal rate of 4%.

Normally in a business cycle, the nominal rate will rise as real rates rise… going up along one of the up-sloping lines. Let’s not get too far ahead of ourselves. You can probably already see this is a long post. Let me build the model more…

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I have colored in areas of the graph to represent the constraints.

  • The red area below a 0% nominal rate is not possible. It is the area below the Zero Lower Bound.
  • The area to the left of the line for an inflation rate of 2% is hard to get to when inflation expectations are well-anchored as they are now… and the Federal Reserve will not tolerate much inflation beyond 2%. If inflation begins to rise beyond 2%, the Fed will react to push it back to the inflation target of 2%.
  • The area to the right of the line for 0% represents the area of deflation. It is actually hard for inflation to turn into outright deflation. So there is an economic resistance not allowing inflation to become deflation.

So the interest rates of the US will most likely stay in the white zone in the middle of the graph.

Ok… Where is the US economy in this graph?

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The US economy is at the blue star, which is stuck in a little corner between constraints with little room to move. Somehow the blue star would like to get to the yellow star. But how can it get there?

The Slopes of the Lines

The lines in the above graphs have a slope of 1. At constant inflation rates, a 1% rise in the nominal rate will lead to a 1% rise in the real rate.

  • If the slope of the line is = 1, as the nominal rate rises, the real rate rises at the same rate as inflation does not change.
  • If the slope of the line is < 1 (flatter), as the nominal rate rises, the real rate will rise faster than the nominal rate as inflation drops.
  • If the slope of the line is > 1 (steeper), as the nominal rate rises, the real rate will rise slower than the nominal rate as inflation rises.

If a Central Bank raises the Nominal Rate, How will the Star move?

If the Fed were to raise the Fed nominal rate next month, the star would move along a line with a slope < 1. The real rate would rise faster than the nominal rate and inflation would fall. Hopefully we can all agree to this.

So then how has the Fed been able to raise the Fed rate in the past and reach the yellow star? Wouldn’t it cause disinflation and higher real rates that would choke the recovery? Well, past business cycles had momentum in their expansionary phases to the extent that the momentum would overcome the rises of the nominal rate.

Yet, the Federal Reserve now sees the recovery as fragile. The economic momentum is weak. There is much higher private debt levels and wage growth is going nowhere. Labor actually has much less consumption power. A rise in nominal rates could be too much for the economy and send it into a recession with falling inflation. The more rapid rise in the real rate would be too much for a weak economy.

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You see the path that many fear if nominal rates were to rise too fast. Inflation would turn into deflation and the Fed nominal rate would have to retreat back to the ZLB in shame. It would be an ungracious recession.

What if the star was moved to the left?

To the left?… Are you crazy? That is a prohibited area. Yet this is the idea of top economists, such as Paul Krugman. They want to push inflation expectations higher allowing the real rate to fall even further. Then when inflation begins to pick up, the Fed can raise the nominal rate and the blue star will be flung back toward the yellow star.

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The danger with taking this path is that once you open the door to higher inflation, you might just end up with hyper-inflation.

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You can see the Fed tries to raise the nominal rate to cut off the rapidly rising inflation, but the slope of the line goes greater than 1 and inflation wins.  Is this a real possibility? To many economists it is tempting fate too much.

Putting a Camel through the Eye of a Needle

So the trick to normalizing monetary policy and get back to the yellow star is to raise the nominal rate very carefully… if the economy responds with momentum you are “golden”, which means you have a chance of success. The only way for the economy to get back to the yellow star is to ride upon momentum.

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As the Fed nominal rate starts to rise, the star takes the path with a slope less than 1. Inflation falls and real rates rise faster than nominal rates. Then the Fed waits for momentum. Will it come? Just wait… Let the economy find its strength to meet the challenge. But don’t be afraid of a little fall in inflation, like Sweden. You are still on the path to normalized policy. You are on a similar path to what has worked before in previous business cycles. But you have to just wait for the momentum to build on this socially-optimal path. The momentum should arrive to carry you safely and surely to the yellow star.

At some point, the slope of the line will have to turn greater than 1. There will have to be sufficient momentum and demand to support rising inflation. This is the Fisher Effect bringing the economy to its socially-optimum natural real rate. The Fisher Effect describes the periods when rising nominal rates coincide with rising inflation. Usually this happens at the end of a business cycle when output reaches its natural level, and where economic momentum translates into inflation instead of higher output.

There is a synergy of economic activity as the economy approaches the yellow star. This is the Fisher Effect. Inflation tends to want to rise around the yellow star at full employment. At least that has been the experience in past business cycles. If the momentum never comes, then there really was no hope of ever getting safely back to the yellow star in the first place.

What does it mean to be “Behind the Curve” in monetary policy?

In order for the blue star to go to the yellow star, there has to be enough time and spare capacity which is consumed along the way. So a Central Bank has to start moving nominal rates toward the yellow star early enough in the business cycle in order to have enough fuel (spare capacity) to get there. If there is not enough spare capacity, then momentum will not build well enough. The Central Bank would not be able to raise nominal rates without the rise in real rates overcoming the lack of spare capacity. The economy would fall into a recession with disinflation and maybe deflation.

The Fed must be careful with a delicate economy that has been abused by the rich creating inequality and weak effective demand from labor. But is the Fed being too careful? The longer the Fed waits to raise the Fed rate, the more spare capacity is consumed. The less fuel there will be for completing the trip to normalized monetary policy.