Can Tinkering with Interest Rates Solve All Inflation?


Modern Monetary Theorists believe fiscal authorities, rather than monetary authorities, should take the lead in addressing inflation, and that when monetary policy does act, it should do so with direct credit regulation rather than by relying on nominal interest rate adjustments. Mainstream economists are skeptical of this position and believe that the central bank’s raising rates is sufficient and necessary to stabilize the price level. For example, on April 13, 2021, Economist Paul Krugman stated that “any inflation threat from overheating can be contained by monetary policy; MMTers don't believe in monetary policy, for unclear reasons, so their doctrine gives more reason to worry.” Conventional monetary policy means focusing on the central bank's policy rate, and Krugman’s characterization of monetary policy's ability to achieve its desired ends without "reason to worry" is at odds with even the most uncontroversial empirical research. From the standpoint of MMT, if a policy to reduce inflation takes several years for it to take effect or causes harm that is worse than the impact of the inflation, then it is a failure. There are several reasons why we have reason to doubt that interest-rate focused monetary policy can contain "any" inflation threat from overheating in the desired timeframe, unless we are willing to accept significant collateral damage. This article will address several of these doubts and also discuss why the framework of looking at inflation primarily as a problem of overheating is flawed.


Weak Empirical Evidence for the Substitution Effect Dominating the Income Effect


One of the ways raising nominal interest rates is supposed to reduce inflation is by encouraging household saving. The theory states that raising the rate of return on deposits encourages households to refrain from spending by rewarding their patience. A phenomenon called the substitution effect holds that if interest rates increase from 0% to 5%, then saving $1 today allows a person to substitute that current consumption with $1.05 of consumption in the future, which encourages additional saving. However, a second phenomenon called the income effect holds that if interest rates increase from 0% to 5%, the additional income to the deposit holder means that they only need to save $1 today in order to spend $1.05 in the future, which encourages additional consumption. Several factors, including (i) time preference, (ii) years left in the person’s lifetime, (iii) their desire to leave a bequest when they die, (iv) their saving framework (whether they target a specific amount of saving, save according to a rule of thumb, or simply try to maximize overall saving), and (v) whether they hold physical capital in addition to bank accounts, determine whether the substitution effect or the income effect dominates an individual’s decision to save or consume when interest rates change.

Douglas W. Elmendorf, writing for the Federal Reserve Board in June 1996, performed a comprehensive review of the literature and additional empirical research into whether raising interest rates actually increased household saving. He found that while there was some reason to believe that households increase saving when interest rates increase, the evidence as to the magnitude and reliability of this response was mixed at best. Although Elmendorf states his belief that "on balance that the aggregate interest elasticity of saving" is likely positive, because the factors mentioned above vary widely across households, he concluded that “it is simply not possible to provide a precise estimate of the interest elasticity of saving with any confidence.” This may explain why—in order to stem inflation—the monetary authority usually must raise rates in such a manner as to cause "collateral damage" in many sectors of the economy, in the words of Fed Governor Christopher Walker. This analysis of the heterogeneous effect of rate hikes implies that we should be looking at other solutions as well.


Fixed Rate Debt and Rate Insensitivity


Another way interest rate hikes are supposed to reduce inflation is by increasing household debt payments, leaving consumers with less money to buy goods and services, preventing them from bidding up the price of those goods and services. However, this effect is muted by two things, the predominant type of mortgage type in the economy and consumers' lack of sensitivity to borrowing for certain types of debt. The largest form of consumer debt that changes with interest rates is mortgage debt, but not every mortgage rate adjusts with the central bank’s policy rate. If an economy primarily uses adjustable-rate mortgages, consumer spending might respond well to interest rate increases, but if it uses fixed-rate mortgages, this channel of monetary policy is significantly weaker. In countries like the US, where the vast majority of mortgages are fixed rate, this channel is much less effective.

The other major type of consumer debt is credit card debt, which does not respond to increases in interest rates. Joanna Stavins, writing for the Federal Reserve Bank of Boston, observed what happened to credit card APRs when the rates on treasury bonds changed. She found that when the treasury rate decreases, credit card APRs remain high because banks can adjust annual fees and “bells and whistles” to remain profitable. In addition, banks use high APRs to screen for lower risk customers, which increases their profits, giving them an incentive to keep APRs high even when the cost of funds decreases. In other words, the amount of credit card debt is not a function of the central bank’s policy rate, but of the risk profile of borrowers and the risk sensitivity of banks. Because banks have different risk preferences and different customer bases, they do not need to compete for customers by offering the lowest APR.


The Interest Cost Channel


One way raising interest rates can increase prices is through the interest cost channel. Roughly half of small businesses borrow money every year to meet basic operating expenses, such as rent and payroll. If the cost of borrowing goes up, the cost of doing business for most firms also goes up, and many firms will pass this cost onto their customers. Eugenio Gaiotti and Alessandro Secchi, writing for the Journal of Money, Credit and Banking in December 2006 investigated over 2,000 Italian businesses and found “robust and direct evidence” that firms do in fact raise prices in response to interest rate hikes. In this way, rate hikes work in the exact opposite direction as intended. If firms are not able to pass this cost onto their customers and close, aggregate supply will reduce, which could put further upward pressure on the price level.


Insensitivity of Investment to Interest Rates

Even if a firm doesn’t need to borrow to meet its operating expenses, it might need to borrow to invest in its own expansion. According to mainstream economic theory, increases in the central bank’s policy rate should decrease investment by firms. Presumably, firms proportionately reduce their borrowing as interest rates increase to minimize their debt expenses. According to Steve A. Sharpe and Gustavo A. Suarez writing for the Federal Reserve, there is little reason to believe firms behave this way in the short term so reliably that interest rate hikes can quickly and easily reduce consumer prices. Instead, if firms' borrowing costs increase, they will first look to finance their projects by borrowing less and spending more from their retained earnings and operating income. In addition, firms make borrowing decisions based on the profitability of the investment, regardless of the financing cost. Most companies tend to set a “hurdle rate”—a desired rate of return they need to anticipate before making an investment—and will find some way to finance any project that meets this number. Therefore, increasing the cost of financing does not deter them from making investments until the investment goes below their hurdle rate. Raising the policy rate may not have much effect on whether a firm’s project clears that firm’s hurdle rate, particularly if the firm can partially finance the project from profits or by selling equity. Furthermore, if the income effect discussed above increases purchases by some consumers, this could cause firms to expect higher profits, meaning that firms would expect their projects to be more likely to clear their hurdle rate. Consequently, the effect of interest rate increases on investments by businesses is indirect and dilute.


Currency Competition

Lastly, in many countries, particularly developing countries, even if interest rate hikes deter borrowing, they might only deter borrowing in the specific currency affected by the rate hike. International financial markets grant firms (and households) the ability to choose which currency to borrow to finance their purchases, and they tend to choose whichever currency lets them borrow more cheaply. According to Brown, Onenga, and Yeşin’s study for the Swiss National Bank in 2009, “when foreign currency funds come at a lower interest rate, all foreign currency earners” in addition to “local currency earners with high revenues and low distress costs” choose foreign currency loans. In other words, if a country’s central bank raises rates, borrowers might borrow less of the local currency and an equivalent amount of money in foreign currency. If a borrower spends the borrowed foreign currency on local goods and services, that spending will have the same inflationary effect as if the money were borrowed in local currency. For example, if there is an electricity shortage in Mexico, and a business in Mexico borrows money to buy power to sustain its operations, the additional power purchases contribute to the shortage and place upward pressure on the price of energy in Mexico regardless of whether the business borrowed pesos or dollars to pay for the additional electricity.


Little Evidence for Low Interest Rates Causing Inflation

In addition to the fact that there is very little evidence raising rates reduces inflation, the evidence that low interest rates are inflationary to begin with is weak at best. The experience of the United States in the last decade and the experience of Japan over the last several decades have taught us this. Jeff Faux wrote in 1995 that there was no “empirical evidence to support [the Federal Reserve’s] series of preemptive strikes against phantom inflation.” Twenty-six years later, there are several empirical studies on interest rates inflation, which were performed not only in the US and Europe, but also in Malaysia and in forty developing countries in the Islamic world. All three studies fail to find that low interest rates cause inflation, and two find that high interest rates cause inflation. There are studies which purport to demonstrate how high interest rates can reduce inflation, but virtually all are fundamentally flawed because they do not directly control for the government’s fiscal position.


What MMTers do *not* say about interest rates


There is a common misconception that MMTers all believe that interest rate hikes either do nothing or always increase inflation. Neither is the MMT position. For example, Professor Stephanie Kelton, "did not argue" in the Deficit Myth that rate hikes will lead to higher inflation; instead, she points out that whether rate hikes are likely to lead to higher inflation is "an empirical question" deserving of more rigorous study. MMTers emphasize that because the "rate hikes can have effects opposite to those intended" because transmission mechanism is messy." The overall effectiveness of rate hikes as an inflation fighting tool is indeterminate because several things, including the size, maturity, and distribution of government debt can undermine the effect or fate hikes and "potentially" cause a stimulatory effect.

Similarly, L. Randall Wray and Yeva Nersisyan do not argue that monetary policy does nothing or that rate hikes are always stimulatory. Instead, they argue that because interest rates are a "very imprecise tool for influencing prices," "small rate hikes do not reduce inflation. It takes large rate hikes that create financial crises, insolvency, and bankruptcies severe enough to crash the economy—followed by jobless recoveries." In other words, Wray and Nersisyan believe that because rate hikes are a blunt tool, a soft landing is impossible.


Conclusion

Interest rate hikes are supposed to be able to slow price increases by cooling down the economy by reducing consumption by households and firms. However, at every step in this process, especially in the first two years following a rate hike, there are factors that substantially diminish the desired effect or work in the opposite direction, which means to achieve the desired effect on inflation immediately, the monetary authority needs to overcorrect. Most central bank officials are aware of how blunt their inflation-fighting tools are. In the words of one former Bank of England official, when inflation is high and worker bargaining power increases, "the central bank has no choice but to cause a recession." From the MMT perspective, a policy that reduces inflation by intentionally creating a recession to harm workers is a moral failure. That alone should be reason to actively look for solutions beyond monetary policy to control inflation. However, it is also important to note that not all increases to the price level come from excess demand or excess borrowing. We should always be on the lookout for price increases that come from oligopolistic behavior, supply chain issues, and shortages. Furthermore, as I have written in the past, even in the most cited examples, there’s little evidence that suggests that monetary policy works to slow price increases without the help of fiscal policy, and as Nathan Tankus has written, there are ways to directly regulate borrowing without relying on interest rates. I suggest we flip Krugman’s statement on its head. Rather than ask why MMTers have so little faith in conventional monetary policy, we should instead ask why mainstream economists have so much.