Understanding Inflation and Interest Rates

Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the central banks, to manage inflation.

The Central Bank directs the Ministry of Finance to promote maximum employment and stable prices. Most countries target an annual inflation of 2% as consistent with the stable prices portion of its dual mandate.

The Central Bank targets a positive rate of inflation, defined as a sustained rise in the overall price level for goods and services, because a sustained decline in prices, known as deflation, can be even more harmful to the economy. The positive level of inflation and interest rates also provides the central bank with the flexibility to lower rates in response to an economic slowdown.

How Changes in Interest Rates should affect Inflation

When a central bank responds to elevated inflation risks by raising its benchmark interest rate it effectively increases the level of money available to the public in a close to risk-free environment (deposits), limiting the money supply available for businesses to grow or for mortgages.

Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available for businesses to grow or for mortgages.

By increasing borrowing costs, rising interest rates also should discourage consumer and business spending, especially on housing, retail shopping and capital equipment. Rising interest rates also tend to weigh on prices, reversing the wealth effect for individuals and making banks more cautious in lending decisions.

Finally, rising interest rates signal the likelihood that the central bank will continue to tighten monetary policy, further tamping down inflation expectations.

So, what is the problem?

First, we need to understand that economy is a social science and not an exact one. It is a game of experimenting and seeing if the theory works, then correcting and trying again. There are no guarantees that the theory will work as the regulator expects and even if the theory worked in the past, every event is different so the reaction to the event may have different outcomes than expected.

Add onto this that policymakers often respond to changes that are needed with a lag, and their policy changes, in turn, take time to affect the trends.

Because of these lags, policymakers must try to anticipate future inflation trends when deciding on rate levels in the present. Yet the regulators’ adherence to its inflation target can only be gauged with backward-looking inflation statistics. These can range widely amid economic shocks that can sometimes prove transitory and other times less so.

Ben Bernanke, the US Governor of the Fed said “To sum it up, if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”

Central banks trying to anticipate inflation trends risk could be making a policy error by needlessly stoking inflation with rates that are too low, or stifling growth by raising them. We also have no real proof that the outcome will be aligned with the strategy or if the outcome is aligned with the strategy that it happened because of the regulators policy.

Interest Rates as a tool to leverage or control inflation.

Regulators commonly use interest rates as their primary monetary policy tool. The interest rate, since 2008, is the overnight rate at which banks lend to each other over the very short term.

Traditionally, regulators use open market operations—purchases and sales of securities—to adjust the supply of banking system reserves and hold the national funds rate on target. Demand for reserves was the result of banking reserve requirements imposed to ensure the soundness of banks.

In the years following the 2008 global financial crisis, the focus of bank regulation shifted to capital buffer requirements and stress tests to ensure long-term solvency.

Interest rates and inflation tend to move in the same direction but with lags, policymakers try to manipulate it to estimate future inflation trends, and the interest rates they set take time to fully affect the economy. The theory is that higher rates are needed to bring rising inflation under control, while slowing economic growth often lowers the inflation rate and may prompt rate cuts in the future.