The Fisher Effect under Deflationary Expectations
Federal Trade Commission
January 26, 2011
The response of nominal and real interest rates to expected deflation becomes problematic when nominal interest rates fall toward zero while the expected rate of deflation is increasing. As nominal interest rates approach their lower bound, further increases in expected deflation cannot cause the nominal rate to fall. Either the Fisher equation is violated or the real rate must increase. One way for the real rate to rise is for asset prices to fall. Regressions between 2003 and 2010 of the daily percentage change in the S&P 500 on the TIPS spread measuring inflation expectations show little correlation between asset prices and expected inflation from 2003 until early 2008. However, since early 2008 the correlation between changes in stock prices and in inflation expectations has been strongly positive and statistically significant.
Number of Pages in PDF File: 23
Keywords: Fisher Effect, Interest Rates, Nominal Interest Rates, Real Interest Rates, Inflation, Deflation, Expectations, Asset Prices, Stock Prices, Monetary Policy, Exchange Rates, FOMC
JEL Classification: E31, E43, E52, E63, F41
Date posted: January 27, 2011 ; Last revised: December 23, 2013