In yesterday’s post about the effects of QE2, I discussed the tendency of an increase in expected inflation to cause the prices of real assets, including the prices of commodities, to increase. That is, if we expect prices to rise in the future, we will choose to reallocate our asset holdings, exchanging cash for physical assets, driving up the prices of those assets in the process. So the expectation of increased inflation occasioned last year by the announcement of QE2 undoubtedly was one factor in causing the subsequent run-up in commodity prices, expectations of accelerating economic growth and negative supply shocks being two others.
However, the rise in commodities prices triggered by an increase in expected inflation is not the same as an increase in inflation. Rather it is a once-and-for all adjustment in the relative values of physical assets and money associated with the inflation-induced shift in desired asset holdings. If inflation stabilizes at the newly expected rate, commodities prices will not continue to rise faster than the rate of inflation (for purposes of this exercise I am assuming that inflation is uniform across all good and services). But this also means that measured inflation will tend to overshoot the new higher expected steady-state rate of inflation. I note again that other factors probably contributed to the temporary spike in inflation, but increased inflation expectations, in and of themselves, tend to cause a transitional measured rate of inflation above the new expected rate.
The distinction between steady-state inflation on the one hand and a once-and-for-all increase in prices (apart from the expected increase in inflation) on the other may clarify one of the most puzzling (for me at any rate) passages in the General Theory (p. 142) in which Keynes criticizes Fisher’s distinction between the real and nominal rates of interest. After observing that an expected reduction (increase) in the value of money would tend to raise (depress) the marginal efficiency of capital curve, Keynes goes on to make the following comment on Fisher:
This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. [The latter comment is itself a curious statement by Keynes inasmuch as Fisher was totally explicit in basing the distinction on foreseen changes in the value of money.] There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent.
Keynes, referring to changes in the value of money, seems to have had in mind a once-and-for-all change in the price level rather than a change in the rate of change in the price level (i.e. a change in the rate of inflation). Fisher, however, when discussing the distinction between the real and the nominal rates of interest, was clearly analyzing changes in the rate of inflation . There is a lot more to be said about Keynes’s views on the effect of inflation (or changes in the price level) on the rate of interest and other macroeconomic variables, but this simple point may help to achieve some sort of reconciliation between Fisher’s and Keynes’s views on the rate of interest. Allyn Cottrell wrote a very interesting paper on the subject many years ago. A couple of years ago this subject came up on Scott Sumner’s blog, and Kevin Donoghue was helpful to me in understanding what Keynes was saying. By the way I seem to recall that in the Treatise on Money, Keynes accepted Fisher’s distinction without quibble. If Kevin is out there and would care to weigh in on the subject, I would be glad to hear from him.