Neo-Fisher Reflections

The Fisher Effect would say that steady and low nominal interests would bring down inflation as the real interest rises to its natural level at full employment. OK… nominal interest rates are steady and low and inflation is low. So is it really the Fisher Effect that is bringing down inflation?

Just yesterday I posted that last year my model of the Fisher Effect predicted that inflation would stay low. Now… did inflation stay low due to the Fisher Effect or some other force?

The Fisher Effect should kick in when monetary policy has its hands tied for a long time. Even though we have seen the Fed rate stuck at the zero lower bound for many years, monetary policy has still been tightening because the Fed first stopped QE, then lately they have been saying that they will raise the Fed rate by the end of the year. Expectations of tightening ensued which tightened monetary policy even though the Fed rate and monetary base had not changed.

What about supply and demand in the aggregate economy?

Low interest rates globally are encouraging production on the supply side.

Lower labor share in the US, China and other advanced countries is reducing the consumer demand side. There isn’t strong fiscal policy demand since many other countries are limiting their fiscal spending. China has a strong fiscal stimulus policy but their strong financial repression measures keep inflation low.

So when supply is being boosted and demand is being weakened, prices should want to come down.

The point here is that these dynamics of supply and demand are only indirectly related to the Fisher Effect. The low interest rate could generate inflation if consumer and fiscal demands were increased. But labor share is not rising much, and the US govt debt is falling as a share of GDP. Low labor share and fiscal restraint are not caused by low nominal interest rates. So the dynamics of supply and demand are only indirectly related to any Fisher Effect.

When I look at bank type lending (in real terms)…

bank lend

Lending dropped after the crisis and then started to pick up again in 2013. We can imagine a bubble of lending toward the end of the last business cycle, then lending came back down to a long-term trend in 2013, at which point it started to rise again.

From the interest rate rule that I use, the Fed rate started to fall below the curve in 2013. In effect, the Fed rate started to be lower than the prescribed rate for the economy. The Taylor rule is showing the same trend. Borrowing from the banks should increase under these conditions.

2013 trend

So we have a “depressed” economy. Labor share is low. Fiscal stimulus should could have been stronger. Nominal interest rates were too high after the crisis. Production came back stronger than consumer demand as capacity utilization rose much faster than unemployment fell according to past patterns. The effect was to suppress inflation. But now what, the Fed rate looks to be stimulating the economy. Bank type lending is increasing again. There is hope that this will feed into inflation…

But labor share is still not rising. Capital income may pull back its consumption as the stock markets wobble at the end of the business cycle. The demand side is staying weak. Inflation is weak.

So… is inflation weak from weak demand in the face of supported supply? or is inflation weak from the Fisher Effect where the Fed rate is stuck at the zero lower bound for years and looks like years to come?

I can more clearly see the mechanisms behind weak demand and supported supply, than the mechanisms behind the Fisher Effect. So I put the Fisher Effect up on a shelf until low inflation is no longer explained by weak labor share, weak fiscal stimulus and various types of financial repression vis-á-vis a supported supply side that seems to be in a position to feed itself first upon monetary efforts to stimulate inflation.

The govt should be borrowing and spending more. Labor should be sharing more in the record profits. The Fisher Effect does not explain weak demand. The Fisher Effect does not understand why this is happening.