Rates and Inflation

Bruce Bartlett
Posted: Apr 19, 2004 12:00 AM

 Higher interest rates are coming.  Last week, financial markets got a bit of a jolt when they suddenly realized this fact.  Some analysts are now predicting fairly substantial increases by yearend.  It is important to understand why rates are rising in order to assess their impact.  In the short run, the effect may be to bolster growth.

 Interest rates basically rise for 2 reasons.  The first is that the demand for funds exceeds their supply.  For example, on the demand side, growth in the economy may raise the return to capital, thus encouraging additional borrowing by businesses for investment.  Or government deficits may crowd private borrowers out of the market.  On the supply side, the Federal Reserve may restrict the money supply or foreigners may cease investing in dollar-denominated assets because of a falling dollar.

 The second reason why interest rates rise is because of expected inflation.  This cause was first identified by the great economist Irving Fisher and is often called the Fisher effect.  He observed that a one percent higher expected inflation rate tended also to raise interest rates by one percentage point.  This is because lenders demand compensation for the fact that the future interest and principal they receive will not be worth as much as the money they lend, in terms of the goods and services it would purchase.

 It is important for policymakers to understand that the Fisher effect can cause rates to rise even when the budget is in balance or when private borrowing is falling.  It is simply a function of inflationary expectations.  And inflation is, in the long run, entirely a function of monetary policy.  Prices for certain things may rise at any time.  But the general price level can only rise for more than a brief period if the Federal Reserve pumps too much money into the economy.

 The Federal Reserve has had a highly accommodative monetary policy for more than 3 years.  This was justified by the Fed's previous tight money policy, which brought about the stock market crash and the following recession.  By restricting the amount of money and credit in the economy, the Fed put downward pressure on prices, creating deflation, the opposite of inflation.  But now many analysts believe that the Fed has more than made up for past deflation and is now sowing the seeds of inflation.

 The Fed has not made up its mind on the subject.  Public statements by various Fed officials show that many are still concerned about deflation.  Also, some Fed officials are convinced that inflation can only result when unemployment falls well below where it is today.  However, all Fed officials recognize that the time will come when it must begin to tighten monetary policy.  Some observers fear that it may wait too long in order to avoid influencing the election.

 Right now, the signs are mixed.  Prices for some things like gasoline are up a lot.  But this can be explained by lower oil output in Saudi Arabia and elsewhere and by unusually strong demand in China, which increasingly appears to be in a bubble, with its economy growing at an unsustainable rate.  On the other hand, rising productivity is allowing businesses to raise profits without increasing prices for most goods and services.

 However, it takes considerable time for an inflationary monetary policy to affect the general price level--generally about 2 years.  Moreover, it will not affect all prices equally when it does start to have an impact.  Some analysts argue that the Fed's easy money policy has been channeled mainly into housing prices up until now.  One hears more and more talk about a bubble in the housing market like the one we saw in the stock market in the late 1990s.

 But money is fungible and eventually spreads throughout the economy.  In the early stages of inflation, it raises corporate profits because businesses can raise their prices faster than their costs rise, especially for labor.  Thus it is not contradictory for the stock market to rise even as interest rates rise--if the basic cause is an inflationary monetary policy.  Furthermore, investment may not be impaired because companies will be able to raise capital in a rising stock market, rather than borrowing in the bond market.

 Although the Fed's easy money policy and rising inflationary expectations are the primary cause of rising rates, in my view, there those who say that the federal budget deficit is the main culprit and that higher taxes are needed to bring down interest rates.  They would do well to remember that rates rose sharply after Bill Clinton's tax increase in 1993.  In 1994 alone, a year when the budget deficit fell sharply, rates rose by 2 full percentage points.

 As in medicine, a proper diagnosis for the economy is essential before implementing a cure.