-3
$\begingroup$

As raising the interest rate immediately effects the mortgages payments, households will have less money to spent on other goods, which will cause lower profitability of manufacturers and businesses. This should stop prices increase already in the short turn. So why it is common to say and to see that raising the interest rate slows down the inflation just after at least a year?

Especially when mortgages repays are not included in the CPI I guess the CPI would drop instantly in this case.

$\endgroup$
1
  • $\begingroup$ Note that interest rates have been raised gradually. If, a year ago, the Fed raised interest rates by 5 percentage points all at once, then the effects would have hit much more quickly. $\endgroup$
    – Daniel
    Commented Jul 8, 2023 at 15:20

2 Answers 2

-1
$\begingroup$

In the short run, the effect is not immediate for a few reasons:

  1. The impact of interest rate changes takes time to filter through the economy. It takes time for households and businesses to adjust their spending and investment decisions in response to higher interest rates.

  2. Prices are often sticky in the short run, meaning they do not adjust immediately to changes in demand or production costs. This delay in price adjustments can temporarily offset the impact of higher interest rates on inflation.

  3. The effectiveness of interest rate changes in controlling inflation depends on how well they influence inflation expectations. If people expect inflation to persist, they may not change their behavior in response to interest rate hikes, and the impact on inflation may be limited in the short run.

$\endgroup$
1
  • $\begingroup$ In point 1, why exactly does it take time for rates to filter through? Without any explanation you just restate what the OP was questioning. $\endgroup$
    – BrsG
    Commented Jun 8, 2023 at 10:32
-4
$\begingroup$

There are several possible reasons why raising the policy interest rate of the central bank does not lower inflation in the short run.

Firstly, let's briefly review the standard monetary policy transmission mechanism (MPTM). It posits that by increasing the interest rate paid out on central bank liabilities (reserves), a chain of causes and effects will occur to lower the rate at which the price level increases, primarily due to a reduction in aggregate demand in the domestic economy (and potentially cheaper imports). See the Bank of England explainer May 2023.

The theory for this asserts that commercial banks seeking to borrow reserves in the inter-bank market will face higher rates as a result of an increase in the Bank rate - because lender banks won't lend for anything less than Bank rate if they wish to maximise their returns (this is a core assumption). They therefore face a higher cost of funds, which banks respond to by increasing the rates they apply to customer loans.

Now, customers are expected to respond to this higher cost of borrowing by reducing their demand for loans and, because savings rates are also increased as a result of banks' attempts to attract reserves, postpone consumption by saving. The broad money supply available for spending is therefore expected to reduce - or at least grow less quickly - since the rate at which new loans are made is now less than the rate at which old loans are repaid. Households and businesses will also tend to adapt the composition of spending away from non-core goods and services in the CPI and towards higher interest payments on their debts (eg. mortgages) - more detail here. The higher interest rates will therefore reduce demand in the economy and CPI prices will be expected to rise more slowly.

Now why does this often not happen in the short term?

One reason is that it takes time for spending and investment behaviour to adjust to the higher rates. This is particularly true since many loan agreements these days have fixed-term rate structures such as 5-year fixed rate mortgages. If you took out a 5-year mortgage at 1% a couple of months before the policy rate was hiked to 5%, you will face no increase in interest payments for at least 5 years. Your spending behaviour may therefore not change that much as a result. Naturally, there is a distribution of loan types across the economy with varying maturities, rates, and fixed/variable proportions but it is expected that a delayed effect will be the result of this mixed distribution.

Additionally, high interest rates have the potential to actually be a cause of higher prices. Many developed economies these days are highly leveraged with debt, particularly post Global Financial Crisis (GFC) with businesses and households having to take out increasingly large loans to finance spending and housing/premises services. See this IMF piece. Businesses faced with an increase in their interest payments may well respond by pushing up prices of the goods and services they sell to maintain profitibility. This effect will be competing with the downward pressure of a slowing of demand, but the price result on price will depend on the specific interplay and relative strengths of these opposing drivers on the price level.

Moreover, interest payments are always simultaneously a cost to one party and an income benefit to the other. The interest income channel, if large enough, has the potential to disrupt the standard MPTM by actively stimulating spending. Interest payments represent a composition change of the domestic private sector's financial assets. Savers gain and borrowers lose. If savers start getting increased interest income before borrowers as borrowers shift into new loan aggreements over time, this income could act as a short term injection of spending on CPI goods and services, holding up inflation until the traditional MPTM acts to counter this demand. This effect could be even larger if you consider interest income on interest-paying Treasury liabilities (bonds). The US, for instance, is increasing its net spending (deficit) to accommodate a large increase in the interest they are paying out on bond assets held by the non-government sectors. This income could be stimulatory in nature, but at the very least could act as a counteracting effect on demand shrinkage.

Nobel-prize winning economist Joseph Stiglitz has also discussed a number of reasons why rate hikes could make inflation worse, particularly in the short term. A major possible reason is inflation is often supply-side cost-push, rather than demand-pull, resulting from energy & food price increases and production/supply chain bottlenecks. Higher rates will act to reduce demand for borrowing for investment by businesses. This reduction in investment may well prolong the time it takes to solve production and supply problems, thereby holding up price rises for longer. This lack of investment could also act as a longer-term drag on economic growth and productive output, which is a key determinant of the price level.

Equally, high rates are known to result in an increase in rental prices for housing and cause a compositional shift away from home ownership in the medium term. This Federal Reserve paper considers this effect and finds the shelter component of the CPI rises with increasing rates, contributing to holding up inflation.

.. we find that low responses of overall consumer prices to monetary policy shocks are the result of strong opposing movements in nominal housing rents..

To conclude, it is clear that monetary policy movements contribute to opposing and counter-intuitive effects on inflation with several mechanisms available to move prices against the desired direction of policy setters. It is therefore important to evaluate monetary policy in the round and consider all economic impacts when setting monetary policy in response to price rises.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.