Fisher Effect

The Fisher Effect states that the nominal interest rate equals the real interest rate plus expected inflation: i = r + π^e. Lenders demand compensation for the erosion of purchasing power, so as inflation expectations rise, nominal rates rise in tandem — leaving the real rate roughly constant over time. The practical implication: don't confuse high nominal rates with high real returns. A 10% nominal rate in a 8% inflation environment delivers only ~2% real return — the same as a 4% rate with 2% inflation. For founders, the Fisher Effect is a discipline for evaluating debt, capital costs, and investment returns in real terms. It also explains why interest rates move with inflation expectations and why central banks focus on managing those expectations.

Always decompose nominal rates into real rate and inflation expectation. When evaluating debt, returns, or cost of capital, ask whether the number is nominal or real. Use the Fisher equation to compare across time periods or countries with different inflation levels. In forecasting, track inflation expectations (e.g. breakeven rates from TIPS) to anticipate nominal rate moves.

Fisher Effect: nominal interest rate = real rate + expected inflation. Always decompose rates into real and inflation components before comparing or deciding. High nominal rates don't mean high real returns; the distinction matters for debt, valuation, and capital allocation.