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u'f\xa4hre'is a unicode string, not encoded as anything. The unicode codepoint 0xa4 is the character ä. It is not really important that ä would also be encoded as byte 0xa4 in ISO-8859-1.
The unicode string can contain any unicode characters without encoding them in some way. For example 轮渡 would be represented as u'\u8f6e\u6e21', which are simply two unicode codepoints. The UTF-8 encoding would be the much longer '\xe8\xbd\xae\xe6\xb8\xa1'.
So there is no need to fix the encoding, you are just seeing the internal representation of the unicode string.
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Not exactly: after having been decoded, the unicode string is unicode which means, it may contain characters with codes beyond 255. How the interpreter represents these depends on the platform, but usually nowadays it uses character elements with a width of at least 16 bits. ISO-8859-1 is a proper subset of unicode. Thus, the string u'f\xa4hre' is actually proper — the \xa4 is a rendering artifact, since Python doesn’t know if (and when) it is safe to include characters with codes beyond a certain range on the console.
UTF-8 is a transport encoding that is, a special way to write unicode data such, that it can be stored in “channels” with an element width of 8 bits per character/byte. In order to compute the proper “external” (or transport) encoding of a unicode string, you’d use the encode method, passing the desired representation. It returns a properly encoded byte string (as opposed to a unicode character string).
The reverse transformation is decode which takes a byte string and an encoding name and yields a unicode character string.