The Neo-Fisher hypothesis
When inflation is below target the conventional monetary policy is to lower nominal interest rates via open market purchases to stimulate economic activity that will eventually lead to higher inflation through a Phillips curve mechanism and eventually higher nominal interest rates via the Fisher relation. In this monetary story trend inflation leads the nominal interest rate, and indeed the empirical evidence in the existing literature suggests that for the U.S. this has been the case.
But when the target nominal interest rate is already at the zero lower bound (ZLB) how does the central bank generate more inflation? Quantitative Easing or QE is the use of alternative methods to increase the supply of money apart from the standard open market purchases of short-term government securities and has been a feature of central bank policy in Japan, the U.S., the U.K. and the European Monetary Union. Unfortunately QE has been a failure at generating higher trend inflation in each case.
Recently John Cochrane (2014) and Stephen Williamson (2014) have suggested an alternative policy they have called the Neo-Fisherian hypothesis. The simple idea is that under a monetary policy rule that targets a nominal interest rate, that rate must rise in order for trend inflation to rise since it is the Fisher relation, the proportional relationship between changes in the nominal interest rate and expected or trend inflation, which governs the long-run behavior of both variables.
In this study I use a simple cointegrated VAR model to test the implications of the traditional view, i.e. that trend inflation causes the nominal interest rate in the long run, versus the Neo-Fisherian view that nominal interest rates cause trend inflation for the U.S. economy. The results of the empirical analysis support the traditional view up to 2008. After that the Neo-Fisherian view has some (limited) empirical support.