Are Higher Interest Rates Inflationary or Deflationary? The Complex Relationship between Monetary Policy and Price Fluctuations

As the debate over whether the Federal Reserve will lower interest rates continues, Unhedged raises an important question: are higher rates inflationary? While higher rates may not be inflationary overall, there is a strong case for inflationary effects on specific index components, such as housing. Additionally, higher rates can imply that inflation is high, which can influence consumer inflation expectations to remain at elevated levels.

Central bankers must recognize that the relationship between interest rates and inflation is not straightforward. They should not assume a direct correlation between the two or be swayed by the financial market’s narrative that suggests otherwise. The challenge lies in the fact that historically, a decrease in US consumer price inflation from around 3-4% to approximately 2% has rarely been achieved without the occurrence of recessions.

The gradual progress towards lowering inflation from the current level of 3.5% will require time for workers and businesses to adjust. In a growing economy, this slow adjustment is a positive sign and not cause for alarm. However, a significant drop in inflation from current levels would likely necessitate a recession or a positive supply shock.

Central bankers are wise to maintain an easing bias as they can respond promptly if growth and inflation increase rapidly. The concept of “opportunistic disinflation,” where central banks wait for a positive supply shock to naturally lower inflation rather than artificially induce a slowdown, is highly recommended in the current economic climate. Being proactive in addressing inflation before it becomes a problem is preferable to trying to correct it once it has already escalated.

In the event of a recession, there is a risk that inflation could fall below target levels, making it difficult to adjust monetary policy effectively. This could result in interventions such as quantitative easing, which should be avoided if possible. It is essential for central bankers to remain vigilant and prepared to act swiftly in response to changing economic conditions to ensure stability and keep inflation in check.

The article raises several critical points about the complex relationship between interest rates and inflation. Central bankers must be cautious about assuming too much about this relationship and must recognize that there may be unintended consequences when adjusting monetary policy. Additionally, policymakers must consider alternative ways of addressing rising prices beyond simply cutting interest rates.

Overall, while reducing interest rates may seem like an attractive solution on paper, policymakers must weigh its potential benefits against its risks carefully before making any decisions about monetary policy actions.

In conclusion, Unhedged raises an important question regarding whether higher interest rates are necessarily deflationary or not. While historically lowering consumer price index has been associated with recessions