Do Expected Shifts in Inflation Affect Estimates of the Long‐Run Fisher Relation?

Abstract

Recent empirical studies suggest that nominal interest rates and expected inflation do not move together one‐for‐one in the long run, a finding at odds with many theoretical models. This article shows that these results can be deceptive when the process followed by inflation shifts infrequently. We characterize the shifts in inflation by a Markov switching model. Based upon this model's forecasts, we reexamine the long‐run relationship between nominal interest rates and inflation. Interestingly, we are unable to reject the hypothesis that in the long run nominal interest rates reflect expected inflation one‐for‐one.

Panel cointegration tests of the Fisher effect

“…In agreement with the results of for example Mishkin (1992), Crowder and Hoffman (1996) and Evans and Lewis (1995), we observe some cases where the estimated slope is significantly less than one. This corroborates the Mundell (1963) and Tobin (1965) story that higher inflation encourages economic agents to substitute money balances for interest-bearing assets, which drives asset prices up and real interest rates down, thus preventing nominal rates from raising enough to compensate for the increased inflation.…”

“…In fact, most studies tend to reject the Fisher effect as a long-run cointegrating relationship (see, for example, Rose, 1988;MacDonald and Murphy, 1989;Bonham, 1991;King and Watson, 1997). Other studies, including Mishkin (1992), Crowder and Hoffman (1996), and Evans and Lewis (1995), do not reject cointegration, but with an estimated slope on inflation significantly different from one.…”

“…As pointed out by Evans and Lewis (1995), this critique is likely to be particularly important when testing the Fisher effect, as the forecast error of inflation can be highly persistent because of anticipated process shifts. But if ε it is nearly nonstationary then so is z it , suggesting that tests based on the residuals from (5) will tend to be biased towards accepting the no cointegration null.…”

Structural Breaks, Inflation and Interest Rates: Evidence from the G7 Countries

“…Fahmy and Kandil (2003) [54] conclude that the ability of nominal interest rates to capture inflationary expectations increases with maturity, attaining a one-to-one relationship for assets of five-year maturity. On the other hand, numerous studies, including that of Fisher himself, test the Fisher effect using short-run interest rates (e.g., Mishkin (1992) [5] and Evans and Lewis (1995) [55]). …”

Are Inflation Rates Really Nonstationary? New Evidence from Non-linear STAR Framework and African Data

“…For a wide variety of reasons, their research has given rise to several studies examining whether the inflation rate can be thought of as exhibiting a degree of stochastic nonstationarity. For example, using data for industrialized economies, in particular the United States and the United Kingdom, several eminent scholars[see, for example, Baba, Hendry and Starr, 1988;King, Plosser, Stock and Watson, 1991;Johansen, 1992, Ericsson andIrons, 1994;Evans and Lewis, 1995;Crowder and Hoffman, 1996;Ericsson, Hendry and Mizon, 1998;Crowder and Wohar, 1999;Hendry, 2000;Ng and Perron, 2001;Rapach, 2002;Beyer and Farmer, 2002;Rapach and Weber 2004;Lee, 2005;and Russell and Banerjee, 2008]have determined that the inflation rate exhibits a degree of stochastic nonstationarity. As Johansen (1992:313) put it, "Some time series such as the log of prices (P), have the property that even the inflation rate ΔP is nonstationary, whereas the second difference Δ2P is stationary."…”