It seems like we can’t go more than a few days without talking about inflation or interest rates. On today’s show we’re taking another look at how interest rate policy can be effective at fighting inflation, and where higher interest rates will make no difference at all.
We keep hearing from the Federal Reserve board of governors that they will continue to increase interest rates until inflation is brought under control. It’s as if there is a scientific relationship between higher interest rates and lower inflation. On today’s show we’re going to look deeper at this question and see if we agree with that notion.
In my mind, Interest rates affect capital expenditures, and they affect the cost of financing operating capital. If interest rates go up, my costs go up as a business owner. It means that I may have less money to spend on my business for things like staff and labour. It means the cost of borrowing go up. The biggest costs for borrowing are on buildings, equipment and inventory.
In the broader economy, interest rates can also affect consumer spending on discretionary items. That’s partly why an increase in interest rates will cause a reduction in GDP and risks pushing the economy into recession.
The increase in fuel prices is a global phenomenon, that has more to do with global supply and demand, geopolitical factors involving Russia, and less to do with loose monetary policy by the Fed. Cheap money would theoretically help the oil industry increase production, but we have had cheap money and money printing for more than a decade and frankly that has not benefited the energy industry very much at all. So raising interest rates won’t cause the price of oil or natural gas to go down.
Some items in the economy can be considered highly inelastic with price. For example, if your distance to work is 20 miles, you are going to drive 20 miles to work, even if the price of gas goes up by 50%. This may reduce your spending elsewhere in your monthly budget. But if the Federal Reserve raises interest rates, you are not going to drive a shorter distance to work, and you are not likely to change.
To that extent, the change in interest rates won’t affect the price of energy. Since there is a direct connection between economic output and energy consumption, an increase in energy prices will always cause prices to increase across the board in virtually every sector of the economy.
Host: Victor Menasce