Fisher Effect

What is the Fisher effect? The Fisher effect describes the relationship between the inflation rate and the nominal interest rate.

Suppose your grandma lends you $100 at an interest rate of 10%. That's right, this grandma has an interest rate. But suppose also that over the year the inflation rate is 10%. So at the end of the year, you pay your grandma back $110. That looks pretty good on paper, but during that year, money has become less valuable. Due to inflation, what used to cost $100 now costs $110. So what's your grandma's real return? Zero.

More generally, we can write that the real interest rate is equal to the nominal rate, the rate charged on paper, minus the inflation rate. Inflation reduces the real return on a loan. So if grandma expected the inflation rate to be 10%, then in order to get a real return of 5%, she must charge you a nominal interest rate of 15%.

Now you make think Grandma's cold for charging you a 15% interest rate, but she isn't alone in this behavior. Everyone does it, and it's called the Fisher effect, named after the great American economist Irving Fisher. The Fisher effect observes that nominal interest rates will rise with expected inflation rates.

We can see the Fisher effect in this data from the United States. Notice for example how interest rates and inflation rates were low in the 1960s, but as inflation increased so did interest rates. Interest rates reached a peak of almost 20% when inflation hit 15% per year. Since that time, inflation has fallen, and so have interest rates.

So to recap, the Fisher effect describes how interest rates and expected inflation rates move in tandem.