The Dangerous Logic Of The Steady-State Fisher Effect

Noah Smith brought up the issue of the long run Fisher effect. Yet, he wants to see micro-foundation models.

“Specifically, what I’d be interested to see is for someone to find some micro-foundations for the Neo-Fisherite result that don’t depend on fiscal policy reaction functions.”

He found a paper written by Stephanie Schmitt-Grohé and Martín Uribe where they offer a solution to the liquidity trap using the Fisher effect. They conclude…

“Finally, the paper identifies an interest-rate-based strategy for escaping the liquidity trap and restoring full employment. It consists in pegging the nominal interest rate at its intended target level. … Therefore, in the liquidity trap an increase in the nominal interest rate is essentially a signal of higher future inflation. In turn, by its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump.”

 

What does “pegging the nominal interest rate at its intended target level” mean? The US Fed would peg the Fed rate at 4% or so, which would imply a 2% inflation target with a 2% natural real rate of interest. In my view, the economy would be much healthier if the Fed had started gradually raising the Fed rate two years ago toward a projected steady rate of 4% to 5%. I would expect a Fed rate around 3% now.  Eventually the economy incorporates a 2% to 3% inflation potential according to the Fisher effect.

The approach to raising and then pegging the Fed rate must express a projected “steady-state”. In this way, the Fed rate must rise gradually on a steady path to the intended target level where it will be pegged corresponding to full employment. The steady-state then draws the broader economy to it. The ultimate goal is to reach and hopefully maintain a steady-state at full employment. Whether or not capitalism has the nature to maintain a steady-state at full employment is a larger question.