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.