RDP 9410: An Empirical Examination of the Fisher Effect in Australia 5. Conclusion

This paper has examined the Fisher effect in Australia. Recognition that the level of inflation and interest rates may contain stochastic trends suggests that the correlation between expected inflation and short-term nominal interest rates in Australia is the result of a long-run Fisher effect in which inflation and interest rates trend together in the long run rather than a short-run Fisher effect in which changes in short-term interest rates reflect changes in expected inflation. These findings have important implications for policy makers. They indicate that the level of short-term interest rates can be an inappropriate guide for monetary policy because a high interest rate that has persisted for some time is an indication that expected inflation is high. Hence the high level of the interest rate is not an indicator that monetary policy is tight, indeed it might indicate the reverse. This suggests that looking solely at the level of short-term interest rates can produce a misleading picture of the stance of monetary policy. Fixation on the level of short-term interest rates either by the public or the central bank can thus lead to inappropriate policies. On the other hand the evidence that a short-run Fisher effect does not exist in Australia, suggests that short-run changes in the short-term interest rate reflect changes in the real interest rate rather than expected inflation. Thus changes in short-term interest rates can reflect the stance of monetary policy.