The Fisher effect on long-term U.K. interest rates in alternative monetary regimes: 1844-2018

ABSTRACT

The Fisher Effect is one of the most widely studied relationships in monetary economics. Previous studies have found little evidence of a Fisher effect in pre-World War I data for the United Kingdom. An explanation for this is the near white noise property of the inflation rate under the Classical Gold Standard. There is more evidence of a Fisher effect in the post-World War II years when the inflation rate showed more persistence. This paper studies the evidence on the Fisher effect over the time period 1844-2018. This period covers several distinct monetary regimes. The monetary regime is an important factor determining the time series behavior of the inflation rate which, in turn, has been shown to be crucial to the strength of the Fisher effect. Distinctive features of the study are the focus on the long-term interest rate and coverage of the current inflation targeting regime in the United Kingdom.

KEYWORDS:

• Fisher effect
• Inflation anchors
• Inflation targeting
• Long-term Interest Rate

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ For the purposes of later discussion, tables include measures for the longer inflation targeting period and for a sub-period during which the Bretton Woods system was in effect (1952:1–1973:2).

² The focus of this paper is the relationship among the monetary regime, long-term inflation expectations, and the long-term interest rate. The monetary regime is an element of the economic structure. The behaviour of inflation and the interest rate depend on this structure as well as on the shocks that hit the economy. Thus, the price level targeting regime during the Gold Standard years may have led to higher inflation variance than inflation targeting in recent years. Greater variance of shocks hitting the economy as well as regime changes in the Interwar Years likely resulted in especially high variance in inflation and long-term interest rates in that period. A detailed consideration of these and other broader economic forces is beyond the scope of our investigation.

³ Benati (2008) documents lower persistence of inflation in the U.K. under the Classical Gold Standard.

⁴ The regressions for the Gold Standard years and for other time periods include 11 seasonal dummies.

⁵ Details for the impulse responses in Figure 2–6 are provided in Figure 2.

⁶ For this estimate to be consistent requires that the long-term interest rate be stationary given the rejection of a unit root for inflation.

⁷ The lower bound for Bank Rate originated in the late 1840s when the Bank of England concluded that overly competitive discounting had contributed to financial instability. See Clapham (1944; p.217).

⁸ In the early years of the Thatcher era, policy was guided by the Medium-Term Financial Strategy. But rules were overridden in the recession of 1980–81. As Minford (1993) characterizes it, the view of the Thatcher administration was a ‘combination of enthusiasm for rules with a reluctance to abandon discretionary response (p.418).’

⁹ The estimated constant terms in the regressions for (2009–2018) are significantly lower than for the 1992–2008 sample. This conforms to evidence from other studies (e.g. Rachel and Summers (2019)) that indicate a decline in the real rate of interest over the past several decades in industrialized countries. Such a shift complicates evaluation of a change in the Fisher effect.