Some of us are old enough to recall very high interest rates during the late 1970s/early 1980s. For example, the 30-year fixed mortgage rate was 11.2 percent in 1979, increased to 16.63 percent in 1981, stood at 12.43 percent in 1985 and was still in double digits at 10.13 percent in 1990. Home buyers in 1991 almost couldn’t believe they could get mortgage rates under 10 percent! In contrast, today’s 30-year mortgage rate is about 3.25 percent. The Fisher Effect can explain much of this variation.
Named after Irving Fisher, an American economist who taught at Yale about 100 years ago, the Fisher Effect explains how inflation can affect interest rates. It states that the nominal interest rate = the real interest rate + the expected inflation rate. The nominal interest rate is just the interest rate we see on a daily basis, such as the current 30-year mortgage rate of about 3.25 percent, or a five-year CD paying 0.6 percent. The expected inflation rate is the inflation rate anticipated by the financial markets, based largely on past inflation. That leaves the real interest rate as the nominal rate minus the expected inflation rate.
During the 1970s, inflation rapidly increased, in large part due to the Federal Reserve Bank’s (the Fed) easy monetary policy, coupled with supply shocks coming from oil price increases (remember OPEC?). Economists dusted off the Fisher Effect in the late 1970s to explain what they observed: Higher inflation led to higher inflation expectations, resulting in higher nominal interest rates.
When looking backward rather than forward in time, we can substitute actual inflation for the expected inflation. For example, in 1979, inflation was 11.3 percent. Hence, that 1979 nominal mortgage rate of 11.2 percent, after subtracting the inflation rate, actually resulted in a real interest rate of -0.1 percent. A good rate for homeowners, but a bad rate for lenders. This helped to create the 1980s Savings and Loan Crisis.
How might the Fisher Effect help to understand interest rates today? Again, the nominal interest rate = the real interest rate + the expected inflation rate. Where might the real interest rates and the expected inflation rate be heading?
Real interest rates have been quite low in recent years, due to a worldwide savings glut. Some of this has been due to an aging population in the developed world (U.S., Europe and Japan). These populations on average tend to have accumulated more savings while consuming less. And China’s population currently saves more of their income than they spend. On the other hand, the Fed’s anticipated small interest rate increases for 2022 and borrowing for the rising federal government debt will put some upward pressure on interest rates. However, real interest rates overall are likely to remain relatively low during the next few years.
That leaves expected inflation as a wild card factor. The most recent inflation rate over the past 12 months came in at 6.8 percent, the highest rate since 1982. (Wages rose 4.8 percent over the same time period.) Supply-side issues, such as supply chain problems (for example, a lack of semiconductor chips), clogged sea ports, and labor shortages caused inflation to increase not only here but globally. These supply issues were expected to be more transitory, but heading into 2022, they are still lingering on.
In addition to the supply-side issues, due to the pandemic and resulting recession, we’ve had a very easy monetary policy (including near zero interest rates and the Fed buying government bonds and mortgage-backed securities). Meanwhile, fiscal policy (governmental spending/taxing) was unprecedented. Recall the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act passed in March 2020, which included direct payments to individuals, unemployment benefit enhancements and loans (essentially grants) to small businesses through the Paycheck Protection Program. CARES and subsequent pandemic appropriations eventually totaled about $5.9 trillion. These polices, coupled with pent-up demand as the pandemic started to recede and new wealth was created in the stock and housing markets, led to a huge increase in demand. On the bright side, in 2020, we experienced the shortest recession on record: just two months. But high demand interacting with supply-side issues led to higher inflation in 2021.
On one hand, a spiral of higher prices and wages could lead to higher and/or a sustained inflation. This in turn could lead to higher expected inflation, causing higher nominal interest rates, somewhat similar to what we experienced in the 1970s/1980s.
On the other hand, the hope is that while these supply issues won’t totally go away, they will improve in 2022 and 2023. At the same time, both monetary policy and fiscal policy will undoubtedly tighten, as the Fed is expected to increase interest rates some, and most of the pandemic’s $5.9 trillion stimulus will have already worked its way through the economy. A recent University of Michigan survey measured expected inflation for consumers to be around 3 percent over the next five years. If inflation moderates during the next couple years, expected inflation and consequently nominal interest rates should stay relatively well behaved. Let’s hope for this outcome.
Dr. Robert Tokle is a professor of economics at Idaho State University’s College of Business.