One of the arguments for low interest rate policy is that inflation is too low and should be raised. Whether inflation is actually too low is not stipulated; to the contrary we’ve shown in prior posts both that there is no basis for an arbitrary target such as 2% inflation and that inflation is higher than official consumer price based gauges suggest anyway.
But let’s put that aside for now. Instead let’s look at the assumption that low interest rate policy causes higher inflation. Have you ever heard even an attempt to justify it? Or is it just one of those things everybody assumes? Like they once assumed the earth is flat? At the very least, it’s not proved.
To the contrary, there is a good case that it works the other way around.
As we noted in our last post, it’s clear that the initial effect of a policy interest rate cut is in an inflationary impulse. In our monetary system money is created by being lent into existence. A reduction in the price of credit results in more borrowing and therefore more money. This increase in supply results in a decrease in its market value. The reduction in the value of dollars means it takes more of them to buy the same stuff. Prices rise.
But then what? After this inflationary impulse has run its course, the increased debt remains. Debt represents demand for money. People need it to service their debt. The more debt, the more demand. The increased demand exerts an opposing force tending to increase the value of the money. This puts downward pressure on prices.
The inflationary impulse gives way to a deflationary hangover. Monetary policy might be said to be pushing on a spring.
We can look at this from an even more general perspective. It is a fundamental economic truth that people only persist in economic behaviors when there is benefit to doing so. This includes lending money. As a first order effect, policymakers can push interest rates below the rate of inflation so that lenders realize a negative real return, but policymakers can’t overturn human nature. There is immense pressure for real rates to return to positive territory. If nominal rates are forced lower for a protracted period, inflation is forced lower as a result. Otherwise private lending disappears and the economy grinds to a halt.
If nominal rates are forced lower for a protracted period, inflation is forced lower as a result.
This is not merely theoretical. Abundant empirical evidence is obvious to anyone open to seeing it. The deflationary crash of 2008 for instance occurred after a sustained period of “emergency” low rate policy and a strong inflationary impulse characterized by notoriously surging energy and realty prices. For years afterward even zero interest rate policy could barely overcome the deflationary undertow. Indeed, over four decades of rate cutting policy each reflation has resulted in inflation at lower highs and lower lows.
And how is inflation doing in Japan?
There can be no question that the assumptions underlying monetary policy are not only unproven, but likely flat out wrong. The earth is round.
11 thoughts on “Do Low Interest Rates Cause Inflation?”
Another theory driving the low rates cause inflation idea is revealed in the idea of issuing money which depreciates every day, implemented best with electronic money. I. E.. the nominal electronic money in your fedcoin wallet goes to $0.99 in 6 months. This would produce pressure to spend before your money evaporates further. Inflation had the same effect as such a depreciation but historically its “advantage” is that it is hidden.
The problem is that without an explicitly evaporating fedcoin, people who want and need to save increase their savings rates instead of spending because they don’t earn significant interest on the savings they’ve already accumulated. So velocity goes down.
That sounds like negative interest rates. It’s essentially equivalent to a bank account that turns $1 into $0.99 every six months, yielding about -2% interest. Another problem with that idea is the existence of physical cash notes which can’t be readily debited (which explains the keen interest of the financial elite in eliminating cash).
A more fundamental problem is that it shares all the shortcomings of low interest rates we just discussed. Negative rates are just one embodiment of low rates. The basic premises and flaws of artificially low interest rate policy don’t go away just because the zero bound is breached.
If it were successful, the same forces that would motivate holders of cash to spend it promptly would also motivate people to borrow, increasing debt and thereby increase the demand for currency and the attendant deflationary hangover from each inflationary impulse. It also wouldn’t overcome the second aspect noted above; ultimately human nature takes over and all private lending ceases or the pressure for real rates to become positive simply results in a rate of inflation below the rate of interest, i.e. even deeper deflation.
A few moments reflection should reveal why stable and positive inflation is a mere central banker’s fantasy. It is not possible for any security, including central bank notes, to smoothly and reliably depreciate (inflation) for a sustained period. People will short the security (borrow it) until a massive short squeeze develops and the security soars in a rush to cover. This is just what happened in 2008.
Hey! I know this is somewhat off topic but I was wondering which blog platform are you using for this site? I’m getting fed up of WordPress because I’ve had issues with hackers and I’m looking at alternatives for another platform. I would be great if you could point me in the direction of a good platform.
I’m using WordPress, the Argent theme. Sorry to hear you’ve had hacking problems. I haven’t had any here. I’m no expert in web site tech, but it could pay to make sure all your infrastructure is up to date … WP, PHP, plug-ins, and even try a different theme. Keep extras to a minimum. Hope you get the problem resolved.
I think you mean ….. Do manipulated artificially low interest rates cause inflation?
The FED has been on a money creation binge for some time, which is inflation by definition. They are also practicing interest rate suppression. Desperate savers, seeing dollar creation on one hand and experiencing falling savings yields on the other, engage in a chase for yield. Many find themselves in the stock market, often through mutual funds, ETFs, hedge funds, etc. This puts upward pressure on the price of stocks.
The FED has succeeded in putting savers at risk and ruining any expectation of security.
Give the “Maestro” a round of applause. Let him slobber all over himself, as he issues some incomprehensible jargon implying how great he and the FED is. NOT.
Yes … this is about to policy rates, so in this context “low” means lower than market, i.e. “artificially low”.
I am often confused by what the writer means when he uses the word “inflation”. Do you mean an increase in the number of dollars, or do you mean rising prices, or do you mean both?
Like many words, “inflation” has more than just one meaning. In economics it’s used to refer to rising prices or an increase in the quantity of money or credit. I usually use it to mean depreciation of the currency, which can be a result of the latter and a cause of the former.
For instance the fourth paragraph of this post explicitly connects the supply and demand for money with its value and the effect on prices.
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