Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

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. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Tuesday, February 22, 2005

Long Rates, Short Rates,
and the Fisher Equation

Does nobody understand the Fisher Equation?
Or am I missing something?
Since the Federal Reserve began raising short-term interest rates last June, intermediate and long-term rates have moved lower, confounding many observers, even Fed head Alan Greenspan.
The above quotation is from an article in Barron's [$ subscription required], reproduced in The Financial Post [also $ subscription reqd;h/t to Jack].

I don't know for sure, but it looks as if the facts fit this explanation:

Suppose the Fed is tightening the money supply a bit, thus driving up short-term interest rates. This scenario is consistent with their actions last week in which the Fed appeared unwilling to re-fund all the T-bills coming due.

If the above is correct, then it is possible that the markets see this action by the Fed as an attempt to head off serious inflation in the future, which would reduce long rates as the expected rate of inflation drops. This explanation is consistent with this quote from the same article:
The Fed’s policy-setting open market committee reiterated earlier this month that policy makers still expect to raise the fed funds rate target at a “measured” pace, the modifier used by the central bank to describe its anticipated pace of tightening in quarter-percentage-point increments.
The Fisher Equation:

The nominal rate of interest = the real rate of interest + the expected rate of inflation.
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