Flash Economics 06 December 2017 - 1405 Patrick Artus Tel. (33 1) 58 55 15 00 patrick.artusnatixis.com PatrickArtus www.research.natixis.com CORPORATE & INVESTMENT BANKING INVESTMENT SOLUTIONS & INSURANCE SPECIALIZED FINANCIAL SERVICES Does “Neo-Fisherism” make sense? “Neo-Fisherism” is a theory that states that, in the context of the Fisher relation, the nominal interest rate determines expected inflation and therefore inflation and not the reverse. In a country with very low inflation and a risk of deflation, it is a permanent increase (and not a lasting reduction) in nominal interest rates that may lift inflation. We use an econometric approach to determine whether the nominal interest rate does cause inflation, at least in the medium term, in the United States, the euro zone and Japan. Indeed, we find statistical signs of Neo-Fisherism in the econometric analysis for the three countries, with a lagged causality from nominal interest rates to inflation. Distribution of this report in the United States. See important disclosures at the end of this report. Flash Economics 2 Neo-Fisherism describes the opposite monetary policy to that which is typically conducted According to the typical description of the foundation of monetary policy, a reduction in the nominal interest rate pushes down the real interest rate, which stimulates demand and drives up inflation. But the Fisher relation must be considered: Nominal interest rate = Real interest rate + Expected inflation In the medium term, the real interest rate is determined by real features in the economy. If the nominal interest rate is reduced, inflation therefore inevitably falls in the medium term, which is the opposite to how the functioning of monetary policy is typically described. Neo-Fisherism therefore states that to obtain a lasting increase in inflation, the nominal interest rate must be increased (and not reduced) in a lasting manner (the Appendix contains some references). How can the Neo-Fisherian hypothesis be tested? We will focus on the United States, the euro zone and Japan. Charts 1A, B and C compare the central banks key interest rates and inflation; Charts 2A, B and C compare interest rates on 10-year government bonds and inflation since 1980. -505101520-50510152080 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18Chart 1AUnited States: Inflation and Fed Funds rate Fed Funds rate (as %) CPI (Y/Y as %)Sources: Datastream, Natixis -2024681012-202468101280 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18Chart 1BEuro zone: Inflation and euro repo rate Euro repo rate (as %) CPI (Y/Y as %)Sources: Datastream, Natixis-4-20246810-4-2024681080 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18Chart 1CJapan: Inflation and BoJ base rate BoJ base rate (as %) CPI (Y/Y as %)Sources: Datastream, Natixis -4-20246810121416-4-2024681012141680 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18Chart 2AUnited States: 10-year interest rate and inflation Interest rate on 10-year Treasuries CPI (Y/Y as %)Sources: Datastream, Natixis Flash Economics 3 -4-202468102146-4-202468102146802846890294698020460810214618Chart 2BEuro zne: 10-year intest rate nd iflation Euro zne countries a whole xcl. Grec:interst rat 10-yr gvrnmnt bonds CPI (Y/ s %)Sources: Datstream, Natixs-4-2024681012-4-2024681012802846890294698020460810214618Chart 2CJapn: 10-year intest rate nd iflation Interst rate on 10-year government bonds CPI (Y/ as %)Sources: Datstream, NatixsTables 1 and 2 show the correlations between interest rates and inflation rates. Table 1: Correlation (monthly series 1980-2017) Entre Fed Funds rate (as %) Euro repo rate BoJ base rate United States: CPI (Y/Y as %) 0.79 Euro zone: CPI (Y/Y as %) 0.72 Japan: CPI (Y/Y as %) 0.80 Source Natixis calculation Table 2: Correlation (monthly series 1980-2017) Entre United States: interest rate on 10-year Treasuries as % Euro zone countries as a whole excl. Greece: Interest rate on 10-year government bonds (as %) Japan: Interest rate on 10-year government bonds (as %) United States: CPI (Y/Y as %) 0.69 Euro zone: CPI (Y/Y as %) 0.83 Japan: CPI (Y/Y as %) 0.72 Source Natixis calculation These correlations are naturally positive and high. But one must question the direction of the causality between inflation and nominal interest rates. Flash Economics 4 In annual data (Tables 3, 4 and 5): - Changes in inflation are correlated with current and future changes (except in Japan) in nominal interest rates; - Changes in interest rates are correlated with current but not future changes in nominal interest rates, which does not point in the direction of Neo-Fisherism. Table 3: Correlation of annual series (1980-2016) United States Correlation between CPI (Y/Y as %) q CPI (Y/Y as %) q-1 CPI (Y/Y as %) q-2 Fed Funds rate q 0.47 0.39 0.04 10-year Treasury rate q 0.30 0.31 0.13 Correlation between Fed Funds rate q Fed Funds rate q-1 Fed Funds rate q-2