Instead of 4% inflation target, set “net profit rate” target at 4%

The debate over whether the Fisher Effect is real has languished over the past year. It is hard to prove, and even I lost hope in it. However, I may have found the mechanism to make it work.

First, look at this graph of the net profit rate plotted with core inflation since 1958… Chart updated to show “Sweet Spot of Fisher Effect”.

net prof inf3

A recently very high net profit rate of 9% led to a very low inflation rate according to the graph. Firms had little pressure to raise prices with such high net profit rates.

So the key would be to lower the net profit rate to a sweet spot of 3% to 6%. Then firms would have more reason in the aggregate to raise prices to net protect profit rates. Then the central tendency of core inflation would rise to 2% according to the graph.

How could we lower the net profit rate? Drum roll please… raise the Fed rate.

So raising the Fed rate while we are on the right side of the sweet spot would raise core inflation. If we were on the left side of the sweet spot, the economy would contract away to the left from the sweet spot as the net profit rate goes too low. So the Fisher Effect could only work properly (raising the Fed rate to raise inflation) if the net profit rate puts core inflation on the right side of the core inflation target.

The reason why the Fisher Effect has never been seen before is that we have been rarely, if at all, on the right side of the sweet spot since 1958. Net profit rate only topped 4% in 2003 and 2004 when it reached 6%. Since 2009, it has been over 8%!

So instead of a 4% inflation target, it could be better for the Fed to shoot for a 4% target in the net profit rate.

Comments below please…