As the debate over whether the Federal Reserve will lower interest rates this year continues, an important question arises from Unhedged – “Are higher rates inflationary?” While higher rates may not be inflationary overall, there is a compelling argument to be made for inflationary effects on specific index components, such as housing. Additionally, higher rates can imply that inflation is high, which can influence consumer inflation expectations to remain at elevated levels.
It is critical to recognize that the relationship between interest rates and inflation is not straightforward. Central bankers should not assume a direct correlation between the two or be swayed by the financial market’s narrative that suggests otherwise. The challenge lies in the fact that historically, a decrease in US consumer price inflation from around 3-4% to approximately 2% has rarely been achieved without the occurrence of recessions.
The gradual progress towards lowering inflation from the current level of 3.5% will require time for workers and businesses to adjust. In a growing economy, this slow adjustment is a positive sign and not cause for alarm. However, a significant drop in inflation from current levels would likely necessitate a recession or a positive supply shock.
Central bankers should maintain an easing bias as they can respond promptly if growth and inflation increase rapidly. The concept of “opportunistic disinflation,” where central banks wait for a positive supply shock to naturally lower inflation rather than artificially inducing a slowdown, is highly recommended in the current economic climate. Being proactive in addressing inflation before it becomes a problem is preferable to trying to correct it once it has already escalated.
In case of recession, there is always a risk that inflation could fall below target levels, making it difficult to adjust monetary policy effectively. This could result in interventions such as quantitative easing which should be avoided if possible. It’s crucial for central bankers to remain vigilant and prepared to act swiftly in response to changing economic conditions to ensure stability and keep inflation in check.
In summary, while higher interest rates may not necessarily lead to higher prices overall, it’s essential for central bankers to recognize that their relationship with inflation is complex and cannot be assumed based on market sentiment alone. They must take proactive measures to address potential problems before they become more severe and ensure economic stability and low-inflation outcomes are achievable in both short-term and long-term perspectives.