Neo-Fisherism and fiscal solvency: Reinterpreting the determination of inflation, yields, and the debt ratio

Abstract

This study explores the short-run implications of the Fisher effect to help policymakers exit low-inflation environments. Based on Fisher’s theorem, neo-Fisherism predicts that nominal yields and inflation move together over time, creating a common permanent component in nominal yields and inflation, whereby changes in this component cause both variables to co-move already in the short-run (the neo-Fisher effect). Using US data from 1954 to 2018, descriptive statistics, and local projection models, we obtain two main findings. First, the permanent component is closely related to the debt-to-output ratio. Second, changes in this component are serially uncorrelated, cause neo-Fisherian adjustments, and impact the debt-to-output ratio only under active fiscal and monetary policies. Overall, because the long-term nominal interest rate is excluded from the Fisher equation of the fiscal theory of the price level, these results motivate the inclusion of the permanent component into fiscal theory and help policymakers stabilize large (dis-)inflationary pressures.