Why interest rates won’t affect inflation…
in the current – 2008 – economic climate.
Traditionally a National Bank manages the rate of inflation by carefully setting the appropriate interest rate. By increasing the interest rate the National Bank makes it harder, i.e. more expensive, for consumers to secure funds in the form of loans or mortgages. The higher interest rates also make savings more attractive to consumers. As a consequence the consumer adapts his / her spending habits. Spending (purchases) will be deferred and saving will increase. The overall effect is that the consomer has less funds available for purchases (today) and as a result the overall demand for goods drops. A decreased demand reduces scarcity and increases availability of goods. Under these condition prices are less likely to rise and inflation is tempered or decreased. See Figure 1: Supply and demand of typical goods. Inflation could therefore be lowered by an increase in the base interest rate and vice versa.
Figure 1: Supply and demand of typical goods, illustrates reducing demand from (1) to (2) results in the equilibrium price and quantity of a typical good seeing a downward pressure.
The 2008 economic situation is characterised by significant inflation of fuel prices, food prices and raw material prices. The reason for this inflation is twofold.
On the supply side, production can not be increased quickly and requires big investments. This is called an inelastic supply and is illustrated in Figure 2. If we consider a fixed supply curve with limited scope for increase in output quantity, an increase in demand from Q1a to Q2a will result in a large price increase, i.e. from P1a to P2a. If significant investments take place or new technology becomes available, e.g. fusion power or genetically enhanced crops, the supply curve will shift to the right and prices will start dropping. Any technology shift or investment however will take time to yield an effect on the supply market.
Figure 2: An inelastic supply, illustrates that a small increase in demand will result in a large price increase unless a technology shift or investment takes place.
On the demand side, fuel, food and (certain) raw materials are so called essential goods. Essential goods are characterised by the fact that unit price of these goods only has a limited effect on consumers’ demand for these goods. If consumers are faced with a price increase they can not decrease their consumption quickly, i.e. it will take time until they can reduce their requirement for energy (e.g. by improving home insulation…) or food (e.g. by accepting a different diet). As a result the consumers are forced to pay the increased prices.
If households are faced with increased food prices and increased energy prices, they will still buy the food they need and the energy they need because they don’t want to be hungry or cold. If the interest rates are increased, those hoseholds with debts (and most households have debts in the form of a mortgage) will face larger repayments. This will further reduce their ability to improve their energy efficiency (e.g. their house’s insulation) and it will further reduce their ability to buy non-essential products (e.g. consumer electronics). The result is an extended period of high demand for essential goods and an economic slowdown or recession due to a decreased demand in non-essential goods.
An increase in interest rates will therefore not affect consumers’ behaviour when it comes down to those goods that currently see the high levels of inflation, i.e. energy and food. Increased interest rates are likely to reduce the potential investments required to increase the production levels of energy and food. The increased interest rates will also put further financial strain on the available budget of households and limit their ability to reduce their consumption. It will also reduce the budget that would be available to generate a demand for non-essential goods. The overall result is the risk of an economic downturn.
Notes:
1. Jevons paradox
The paradox, i.e. energy consumption will rise as energy efficiency increases, only holds as prices remain constant and energy is abundant. In the current economical situation, the availability (output) of energy is near its maximum and thus limited if consider over a short period of time.
2. Peak oil
According to the Hubbert peak theory the production level of a limited resource will rise, peak and then decrease. Because liquid carbon fuels availability is limited, the aggregate production level of these fuels will eventually decrease because (economical) extraction becomes more difficult.
Further reading:
1. Interesting though slightly different view on the same issue: http://www.johnredwoodsdiary.com/2008/03/10/inflation-in-a-credit-crunch-high-interest-rates-will-make-the-crunch-worse/
