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My understanding is that by raising interest rates, domestic CPI indices are less likely to rise signicantly. However, raising interest rates also attracts capital inflows and can create asset bubbles. Can these asset bubbles not influence the level of inflation? It seems that a high demand for a country’s currency might indirectly cause inflation through asset bubbles even in a floating system. (I’m thinking specifically about the Bundesbank using rates to combat inflation)

Any thoughts appreciated.

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  • $\begingroup$ Examples of asset value calculations are at this link. en.wikipedia.org/wiki/Present_value Higher interest rates will calculate lower asset values for both bonds and equities. $\endgroup$
    – H2ONaCl
    Jan 3, 2019 at 2:33
  • $\begingroup$ My question is about the dissemination of short term interest rates, not a simple present value calculation. My understanding is that asset prices might inflate due to a change in demand, rather than a simple change in discount rate. $\endgroup$
    – Anthony Peter
    Jan 3, 2019 at 6:39
  • $\begingroup$ In your comment below you asked "why do higher interest rates dampen asset prices". The Wikipedia link for "present value" answers the question. $\endgroup$
    – H2ONaCl
    Jan 4, 2019 at 0:44

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You wrote:

How does raising interest rates calm inflation?

If a central bank increases the overnight interest rate, longer term interest rates of government bonds might also rise. The longer term rate of government bonds can approximate the expectation of a series of short term rates. Everybody has a different series in mind so long term rates might decrease rather than increase.

If a private bank can earn risk free by investing overnight or longer term at attractive (higher) rates then they will invest less in individuals and businesses seeking to borrow to consume and purchase investment goods (like equipment and structures and software). If less is consumed and fewer investment goods are purchased then the rate of inflation will be lower.

An asset bubble in gold or Bitcoin is not likely to cause inflation because they are not major inputs in production. There is gold plate in electronics but not all connectors are gold plated. The ones that are not gold seem to work okay.

If oil production is constrained by a cartel, I do not know if that can be called an asset bubble but it can cause inflation.

An asset bubble in real estate can lead to higher rents which is inflationary. Since rents might have been contracted for a year or more the effect on inflation might be attenuated. Since governments often regulate housing rent the effect on inflation might be attenuated. The effect on rent is attenuated since wages change more slowly so ability to pay changes more slowly than real estate prices.

In the graph you can see inflation increased in 1999 and 2005. There was a internet and computer stock "asset bubble" and a real estate "asset bubble" in effect at those times, respectively. It seems CPI inflation can be affected by "asset bubbles". CPI without food and energy also seems to have been affected but not to a large degree. There were times in the chart when inflation was much higher than at these times. This suggests that in the current economic regime asset bubbles might not be the most important risk for inflation and asset bubbles caused by capital inflow might not be either. Perhaps these should not be considered to have been bubbles since some of these assets actually had higher prices in 2018 than in 1999 and 2005, probably even after adjusting for inflation.

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You wrote:

However, raising interest rates also attracts capital inflows and can create asset bubbles. Can these asset bubbles not influence the level of inflation?

I doubt that higher interest rates that attract capital inflow into a particular currency creates an asset bubble because if the higher interest rate attracts the investment, it is usually an investment into an interest yielding security or deposit. When that happens, the price goes up and the interest rate goes down and so it ceases to be an attractive interest rate.

When a currency is highly valued because of capital inflow it can attenuate inflation because imports become less expensive. The net effect of various forces on the inflation rate depends on the particulars.

If locals are a significant contributor to an asset bubble and it coincides with an economic expansion and higher inflation there might be high interest rates because of high loan demand or action by the central bank or both. If locals "believe in" the bubble then that might attract capital inflow at the same time. Outsiders might not be the main cause and they might not be the original impetus. This suggests that the cause is the inflation and the effect is the interest rates; not the other way around.

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I will give you some simplified thoughts in three brief sections:

The traditional view is that higher rates increase the cost of investment and increase the opportunity cost of spending (rather than saving). This places downward pressure on prices. Another way to think about this (opportunity cost part) is considering that higher rates reduce liquidity, which in turn reduces the demand for goods and services.

Asset prices typically move in the opposite direction of interest rates. So, raising rates to cool inflation would actually, according to the common understanding, place downward pressure on asset prices. However, if one looks into the data, one can see that there are co-movements in asset prices and rates. These co-movements are the basis of Karadi's newest paper that is currently R&R'd. However, Gali does have a paper suggesting a link between rates and asset bubbles wherein increasing interest rates can impact the short-run behavior of rational bubbles.

Higher rates can encourage capital inflows. This can cause currency appreciation. This generates its own set of issues.

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  • $\begingroup$ Thanks for the reply. Why do higher interest rates dampen asset prices? It seems as though things like bonds and housing might increase (due to, perhaps, foreigners purchasing these assets) in price while things like equities would decrease (due to slowing corporate growth potential) $\endgroup$
    – Anthony Peter
    Jan 3, 2019 at 0:05
  • $\begingroup$ Also, do you have a link to the mentioned paper? Thanks! $\endgroup$
    – Anthony Peter
    Jan 3, 2019 at 6:42
  • $\begingroup$ Anthony -- i will try to add some links later today. $\endgroup$
    – 123
    Jan 3, 2019 at 16:11
  • $\begingroup$ I also want to note something here -- there is no definitive empirical test for bubbles. The best evidence that bubbles even exist has come from laboratory experiments. Asset bubbles form consistently in certain forms of asset market experiments but not in others. Some economists will argue that bubbles do not exist. So, it is not straightforward to discuss them. $\endgroup$
    – 123
    Jan 3, 2019 at 23:37
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Inflation, as measured by CPI, is showing the rate of change in prices for a basket of goods. If demand increases rapidly for the goods in the basket (or supply decreases), with all other things remaining equal, then under traditional economic theory inflation would rise

Increasing interest rates raises the opportunity cost of spending now versus saving. If more money is saved, less is spent so there is less demand for goods, less upwards pressure on prices and less inflation impact

This works at both the consumer and corporate/investor levels. If a company is deciding whether to invest or not it will use a discount rate which incorporates the cost of money. If interest rates go up this benchmark goes up so an investment in an asset may no longer be made if it is better on a risk adjusted basis to save the money and earn interest rather than making a risky investment or asset purchase

The effect is the same - less money in circulation, less being spent on goods and assets and therefore less inflation

Note this is all from an economics theory perspective and use of interest rates to manage inflation is a cornerstone of Monetary Economics - whether this works in practice either in the short-or long-term is a topic of debate

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