Interest rates, inflation & mechanisms

Reading Noah's discussion of the neo-Fisherite rebellion - the idea that low interest rates lead to lower inflation and higher rates to higher inflation - I heard the voice of the greatly-missed Andrew Glyn. He would ask: what's the mechanism? How, exactly, might interest rates have such an apparently perverse effect?

Let's start with the process whereby higher rates are meant to reduce inflation. The idea here is that they depress demand, thus opening up an output gap (or raising unemployment for those who prefer observable entities), which in turn reduces inflation.

However one big fact suggests that, in the UK at least, this mechanism is questionable. It's that the correlation between unemployment and inflation in the subsequent 12 months has been positive. Higher unemployment has led to higher inflation, not lower.

This is consistent with - though far from proof of - the possibility that higher interest rates do not lead to lower inflation. One reason for this might be that higher real interest rates act like an adverse supply shock. They not only reduce demand, but also tend to raise prices. I'm thinking of three possibilities here.

One was discussed by Fitoussi and Phelps (pdf) in their analysis of Europe's stagflation of the 1980s. Higher real rates, they say, encourage firms to increase their mark-ups to raise immediate cash rather than pursue growth. This is consistent with Rotemberg and Saloner's discussion (pdf) of why price wars are more likely in booms than slumps.

A second is that higher interest rates, especially if associated with less bank lending, tend to deter new companies from starting up or from expanding. This reduces the external restructuring that is a major source (pdf) of productivity growth, which would tend to add to costs.

The third is simply that interest rates are a cost of production - simply because production takes time and inventories, and higher rates raise the cost of both. (Let's ignore reswitching!)

Through these mechanisms, it's possible that higher interest rates act like higher oil prices or other costs of production. They both create unemployment and raise inflation. They raise the Nairu. Equally, lower rates - at least if associated with more plentiful credit - reduce both unemployment and inflation.

Now, there's an obvious objection to this. If lower rates lead to lower inflation why did Thatcher and Volcker raise rates in the late 70s and early 80s in order to (successfully) reduce inflation?

Here's a possibility. It depends on whether recessions have a "cleansing" effect. If they kill off lame ducks and allow productive firms to grow, their effect will be to reduce inflation. If, however, there's no such cleansing effect, they won't. And of course, whether there is (pdf) or isn't (pdf) might well vary from one recession to another.

In this sense, the question "do lower interest rates lead to lower inflation?" might have the answer: "sometimes yes, sometimes no." Maybe the reality is messier than models claim.

Comments

[Hangingnoodles]

"Mechanism" connotes ideas that may be too deterministic for something as complex as an economy. A distinction between ideas & tools "honed in the 'olicausal sciences' (oli = few) handle" vs new ideas/tools for handling greater polycausal complexities may be useful. See Isaiah Berlin on how “because” is used differently in science and history:
http://t.co/4CE301ekLg

[Peter M]

A demand-side mechanism through which interest rates and inflation could be correlated is an Income Effect. Most simply, increases in real interest rates increase the return to savings, which could potentially stimulate demand in the present period because less savings are needed to achieve any specified level of future wealth (same mechanism as a backwards bending labor supply curve).

From a consumption perspective, therefore, if this income effect is greater than its offsetting substitution effect, we could see increasing real interest rates increase consumption. If this increase in consumption is greater than decreases in investment caused by real interest rate increases, we could in fact see demand increase, and thus inflation too.

[chris]

I certainly wasn't intending "mechanism" to be so deterministic. Quite the opposite. The idea I'm driving at is that there are many possible mechanisms which work in opposite directions. Which ones are switched on or off (or are strong or weak) varies from time to time and place to place, and maybe can only be discerned after the event.
That's not very deterministic, is it?

[Luis Enrique]

I could buy the idea that higher rates cause some firms to raise prices, but that sounds like a one off story. Why would higher interest rates cause recurring price increases (inflation)?

[rogerh]

Do higher interest rates depress demand? Maybe this depends on whom the interest rates fall and whether people have any choice about spending and perhaps the age and wealth of the spenders. Up to a point petrol and potatoes and the mortgage are a must-have - no choice. But new cars and new Iphones say have their interest rate kept down or concealed by the vendors and so don't affect demand that much - provided you are not really up against it. Then there are the retired, they might as well spend money as leave it rotting in the bank. The wealthy and the foreigners don't care anyway. So interest rates can go up a fair bit (from a low base) before they bite hard enough to clamp down a low level of inflation. Sadly unemployment can go up and down a fair bit without affecting this picture very much. So I reckon it all depends where on the interest rate/demand/demographic/anydamnthing map you start from and the slope of the curve(s) at those various points. The 1970s and 80s were a very different country.

[chris]

@ Luis - if inflation expectations are adaptive we could get persistent inflation. (The fact that rate rises tend to be serially correlated, and staggered price setting, would also give us a burst of inflation)

[Luis Enrique]

Hi Chris,

so what would be a one-off price level change is transformed into recurring inflation?

that sounds plausible, and as you indicated (adaptive expectations) if this sort of thing happens in reality then rational expectations models are the wrong tools for trying to understand inflation.

[chris]

@ Luis - yes, that's what I'm getting at.
One complication here, though, is that expectations formation isn't necessarily stable. In normal times, folk seem to use adaptive expectations ("inflation will be what it's been"), but in dramatic times they become more forward-looking, as I suggested here:
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2013/11/on-rational-expectations.html

[Luis Enrique]

on the other hand we recently had a burst of inflation, probably from cost push / terms of trade reasons, and that didn't turn into recurring inflation.

one might even have thought, given the number of people who seem to believe that QE will be inflationary, that people would be primed to interpret any one-off inflationary shock as the harbinger of coming inflation and if self-fulfilling adaptive expectations mechanisms are strong, hard to explain experience of recent years?

[Metatone]

I think rogerh adds something important here, along with Luis Enrique's last point. Interest rate _reactions_ to inflationary circumstances are effective or not, depending on what those circumstances are.

Very simply:

An ongoing cost push in a vital, foreign sourced raw material (e.g. oil or gas for many countries) will push up inflation and changing interest rates (basic mechanism, inducing a recession) may not have much impact on price levels affected by said vital material..

On the other hand if there truly is some "wage-price spiral" in action, then inducing a recession can cause wage increases to stop.

Now you can go into intermediate mechanisms about borrowing (short and medium term) & savings (medium term) but the story of effective interventions (e.g. Volcker, Thatcher) almost always involves a recession and I think it's important to take that seriously when looking at mechanisms.