Higher interest rates increase inflation

[Tahuti]

Since it seems to be outlandish economic theories season (I'm talking to you Hygro!), I'm to put forward my own.

Now, I'm not certain how true it would be, and it would be contrary to conventional economic wisdom. However, it is something I wish to explore sincerely, namely, that increasing interest rates indirectly increase inflation.

Of course, neoclassical theory states that higher interest rates will decrease it, which is true - to some extent - scarcity increases prices and those that hold the money are in fact able to decide how scarce it will be.

However, indirectly, this is not so certain. The debts including interest will have to be repaid. If all interest carrying loans were to be repaid with 100% certainty, you can actually have more nominal debt than the nominal worth of the economy! Thus, an increased money supply will be needed to repay it. Increased money supply causes inflation. Now, that may counteract deflation from higher interest rates 1:1, but if its lower than 1 to 1, the debts won't be repaid, so it is far more likely increased money supply - triggered by interest rates - will produce more inflation than the interest rates.

In fact, increasing interest rates may be at the heart of why the economy can't profit from deflation and is in fact harmful, even though deflation was fairly normal before the 20th century century and did not have to significantly adversely affect the economy.

So there is that: While interest rates directly cause deflation, if one counts the political machinations that almost inevitably follow, it will actually be more inflationary.

 

[Timsup2nothin]

Like most things, results vary with the amount of the causal factor.

The invention of the credit card led to people creating debt with far less consideration. The subsequent explosion of consumer indebtedness is very likely a major source of the pernicious inflation of the seventies. Since interest rates on that credit card debt were not really tied to anything but the maximum rate as determined by usury laws (one aspect of the 'far less consideration') changes in the interest rate had very little influence on the rate of debt creation.

Therefore during that period the interest rate assigned by central banks had very little impact on the rate of debt creation. Only when the prime rate was allowed to skyrocket and people buying cars found themselves saying "21 percent!?!? I might as well put it on my credit card!!!" did the average American realize..."hey, I actually have been putting it on my credit card...at 21 percent!!!!"

 

[El_Machinae]

I think the hiccup is that not all debt will be repaid. Some will be defaulted on. So, the debt that gets defaulted on obviously doesn't add to the inflation.

High interest rates discourage borrowing, but new borrowing is where the new dollars some from in order to pay off older debts. The high interest rates do suggest an increase in the money supply, but only if the debtors convince other people to borrow and give the debtors the money.

 

[Hygro]

I'm very open to the idea that high interest rates can be inflationary. It's always nagging the back of my mind when I argue the neo-keynesian IS-LM perspective that high rates = deflationary. Interest income definitely plays a roll. How much, I am not sure. A lot of interest income just accrues and so doesn't factor in to the prices of general goods.

There might be another reason higher rates is inflationary.

That said if high rates can be inflationary, then it's going to depend on the situation. Most recessions occur after/because the Fed starts raising rates (often sharply). Recessions are deflationary. I think the general theory that high rates are deflationary is at worst a decent heuristic.

I do take issue that increasing the money supply causes inflation. I would only argue it trends inflationary.

I think the hiccup is that not all debt will be repaid. Some will be defaulted on. So, the debt that gets defaulted on obviously doesn't add to the inflation.

If a bank creates a 10k loan and gives it to me, and I spend it, and then default, that money never gets paid back so it never cancels out. The bank takes a recorded loss but that's still new money that is floating around the economy that will never get repo'd.

 

[Agent327]

I do take issue that increasing the money supply causes inflation. I would only argue it trends inflationary.

Really? Increasing the amount of money in circulation by definition is inflation.

 

[Timsup2nothin]

Really? Increasing the amount of money in circulation by definition is inflation.

Actually that would be 'increasing the amount of money in circulation relative to the amount of goods and services available'.

 

[Hygro]

Really? Increasing the amount of money in circulation by definition is inflation.

We got a live one!

 

[El_Machinae]

If a bank creates a 10k loan and gives it to me, and I spend it, and then default, that money never gets paid back so it never cancels out. The bank takes a recorded loss but that's still new money that is floating around the economy that will never get repo'd.

Hmmmn, yes. Good point.
I guess what I am saying is that the debt itself isn't guaranteed to create the demand for new money to be borrowed to pay it back. But repaying the debt paper does suck out money.

I guess it's mostly based on people's likelihood to borrow, and then that depends on their expected returns ... animal spirits!

 

[Tahuti]

I was also thinking that increasing interest rates cause businesses that want to get loans to higher their prices to compensate for the interest rates. The actual effect may be very small, and still significant enough to tip the balance.

We got a live one!

The Austrian definition of inflation = increased money supply is not necessarily a bad one. Eventually, one way or the other, money will enter the economy sooner or later. So you might want to think ahead and count that as inflation. Problem is that you don't know when it will be inflationary in the mainstream sense. It might just as well be that the economy grew enough while the money was stuck that it won't have an effect at all.

 

[Borachio]

Like most things, results vary with the amount of the causal factor.

The invention of the credit card led to people creating debt with far less consideration. The subsequent explosion of consumer indebtedness is very likely a major source of the pernicious inflation of the seventies. Since interest rates on that credit card debt were not really tied to anything but the maximum rate as determined by usury laws (one aspect of the 'far less consideration') changes in the interest rate had very little influence on the rate of debt creation.

Therefore during that period the interest rate assigned by central banks had very little impact on the rate of debt creation. Only when the prime rate was allowed to skyrocket and people buying cars found themselves saying "21 percent!?!? I might as well put it on my credit card!!!" did the average American realize..."hey, I actually have been putting it on my credit card...at 21 percent!!!!"

[rant]

I find it really entertaining how people borrow to finance consumption. This has always made zero sense to me. I can understand borrowing money to buy a house the value of which will most likely increase, but to borrow money to buy a car the value of which can only decrease (unless it's a rare model Rolls Royce or something) is just daft. You end up paying more for something that would have cost you less if you'd waited for a year or two. The only reason for doing so is to impress casual on-lookers. And if that's going to cost me hard cash, I'm not going to bother. But it seems I'm an outlier. Along with the people who lend money to the majority of daft borrowers.

If you're going to borrow money, make sure that it results in you gaining money, not losing it.

If you've got a credit card (and I do have one, since it gives me a certain level of protection on some purchases, and is just plain handy), then ALWAYS pay the damn thing off in full every month (before they start charging interest). If you really can't afford to do so, then stop using it until you can.

[/rant]

 

[DemonicAppleGuY]

@Borachio

Although I never borrow to consume (not that I even could) I can see some argument for doing so.

Americans are an optimistic people. We'll always have more, much more even, income in the future. Why not spend against that now to increase our present happiness.

It's a gamble sure, a huge one, but we do it anyways.

 

[El_Machinae]

Borrowing increases the effective price of a good. Borrowing to consume merely means that the good is more valuable to you than the sticker price would indicate. The 'consumer surplus' of the product is actually higher than the sticker price, so people are willing to pay more.

It's a bit of an economic fallacy to consider houses as something that 'increase in value'. They don't, not really. They degrade, too. They just degrade at a different rate than a loaf of bread. They increase in value as a side-effect of other economic growth occurring. They're an asset, not an investment, so to speak

 

[Timsup2nothin]

Borrowing increases the effective price of a good. Borrowing to consume merely means that the good is more valuable to you than the sticker price would indicate. The 'consumer surplus' of the product is actually higher than the sticker price, so people are willing to pay more.

It's a bit of an economic fallacy to consider houses as something that 'increase in value'. They don't, not really. They degrade, too. They just degrade at a different rate than a loaf of bread. They increase in value as a side-effect of other economic growth occurring. They're an asset, not an investment, so to speak

Technically, their 'increase in value' is a function of inflation. So buying a house is a bet on inflation. Borrowing to buy a house is a bet that inflation will exceed the rate of interest.

Purchasing of rental property is obviously an entirely different issue, this post relates only to houses purchased for consumption, ie living in.

 

[luiz]

Did you read about this on Bloomberg? There was a piece by Noah Smith the other day about it, quoting a recent paper by Tyler Cowen or someone along those lines (a Monetarist). I'm not convinced given a very long empiricial history showing that high rates bring inflation down.

 

[Borachio]

@Borachio

Although I never borrow to consume (not that I even could) I can see some argument for doing so.

Americans are an optimistic people. We'll always have more, much more even, income in the future. Why not spend against that now to increase our present happiness.

It's a gamble sure, a huge one, but we do it anyways.

Indeed. And it's not something unique to Americans.

My point is that buying consumer goods on credit actually decreases your happiness; if by happiness you mean the sum total of goods you're able to purchase during your lifetime. You're buying fewer goods at a higher price because you're having to make interest payments on top of the normal purchase price.

 

[Timsup2nothin]

Indeed. And it's not something unique to Americans.

My point is that buying consumer goods on credit actually decreases your happiness; if by happiness you mean the sum total of goods you're able to purchase during your lifetime. You're buying fewer goods at a higher price because you're having to make interest payments on top of the normal purchase price.

While this is common knowledge now, and also readily obvious to even a cursory inspection...

Like me, you are old enough to remember when the BankAmeriCard was a brand new thing and people treated it like the as advertised 'more convenient form of check or cash' without really giving any thought to a slowly accumulating balance...at interest rates fixed by usury laws, not the then fairly low rates on any other type of loan.

 

[Borachio]

I remember people saying that "buying something on plastic" wasn't spending "real money", and apparently believing what they were saying.

But none of this is new. Even before credit cards people, were buying things on credit, calling it hire purchase. And then there were pawn shops. As if those were ever a good idea, they seem to have made a resurgence in the high street just lately.

And what about pay day loans?

I tell you, a lot of people are. just. plain. bonkers. And the rest of them are only too happy to take advantage of the fact.

 

[JohnRM]

Since it seems to be outlandish economic theories season (I'm talking to you Hygro!), I'm to put forward my own.

Now, I'm not certain how true it would be, and it would be contrary to conventional economic wisdom. However, it is something I wish to explore sincerely, namely, that increasing interest rates indirectly increase inflation.

Of course, neoclassical theory states that higher interest rates will decrease it, which is true - to some extent - scarcity increases prices and those that hold the money are in fact able to decide how scarce it will be.

However, indirectly, this is not so certain. The debts including interest will have to be repaid. If all interest carrying loans were to be repaid with 100% certainty, you can actually have more nominal debt than the nominal worth of the economy! Thus, an increased money supply will be needed to repay it. Increased money supply causes inflation. Now, that may counteract deflation from higher interest rates 1:1, but if its lower than 1 to 1, the debts won't be repaid, so it is far more likely increased money supply - triggered by interest rates - will produce more inflation than the interest rates.

In fact, increasing interest rates may be at the heart of why the economy can't profit from deflation and is in fact harmful, even though deflation was fairly normal before the 20th century century and did not have to significantly adversely affect the economy.

So there is that: While interest rates directly cause deflation, if one counts the political machinations that almost inevitably follow, it will actually be more inflationary.

Ultimately, interest necessitates the creation money out of thin air that didn't exist before.

If I have 100 dollars and I loan it to you at 10 percent interest. You have to find a way to create 10 dollars. It is very clearly evident that many people fail to do so, but this does mean that the 10 dollars just disappears. It has already entered the economy on the stat sheets of financial institutions. This is not a problem for those creating productive capacity and putting new goods on the market to warrant the increased wealth. It is a problem when people use to to pay for, tomorrow, what they wish to have today. Many of these things (cars and other consumer goods) depreciate in value at the same time that they are supposed to be creating additional wealth in order to pay their interest. This often NEVER occurs. Instead, the debt is simply rolled over and over until they either tighten their belt, default, or become deceased.

Raising interest rates serves to help reduce inflation, to a degree, simply because it makes loans of this nature more expensive to consumers.

 

[Timsup2nothin]

Ultimately, interest necessitates the creation money out of thin air that didn't exist before.

If I have 100 dollars and I loan it to you at 10 percent interest. You have to find a way to create 10 dollars. It is very clearly evident that many people fail to do so, but this does mean that the 10 dollars just disappears. It has already entered the economy on the stat sheets of financial institutions. This is not a problem for those creating productive capacity and putting new goods on the market to warrant the increased wealth. It is a problem when people use to to pay for, tomorrow, what they wish to have today. Many of these things (cars and other consumer goods) depreciate in value at the same time that they are supposed to be creating additional wealth in order to pay their interest. This often NEVER occurs. Instead, the debt is simply rolled over and over until they either tighten their belt, default, or become deceased.

Raising interest rates serves to help reduce inflation, to a degree, simply because it makes loans of this nature more expensive to consumers.

Yes, you or me can create ten dollars if we have a hundred in exactly that way. But if your bank gives you a credit card with a two thousand dollar limit you can, without any cooperation from anyone, create 2000 plus the minimum payment per month on a 2000 balance for the rest of your life. So when banks issue hundreds of millions of cards they are potentially creating trillions of dollars out of thin air. That creates inflationary pressure that is outside the government's ability to control.

 

[El_Machinae]

The minimum payment doesn't create new money. It creates a demand for you to get someone else to borrow so that they'll give you enough to make your minimum payment.

The original $2000 was new money