Do Expected Shifts in Inflation Affect Estimates of the Long Run Fisher Relation?

Recent empirical studies suggest that nominal interest rates and expected inflation do not move together one for one in the long run, a finding at odds with many theoretical models. This paper shows that these results can be deceptive when the process followed by inflation shifts infrequently. We characterize the shifts in inflation by a Markov switching model. Based upon this model's forecasts, we re examine the long run relationship between nominal interest rates and inflation. Interestingly, we are unable to reject the hypothesis that in the long run nominal interest rates reflect expected inflation one for one