Theses falsified by crisis: The inflation-interest rate relationship

Published 08.04.2016 02:22

We see many assessments that place emphasis on the inflation-interest rate relation these days. Since developed countries consider inflation to be the signal of the beginning of growth, they think they can create inflation (growth) by reducing interest rates to overcome the recession. On the other hand, developing countries still regard inflation as a fundamental problem and think that they can prevent it by pushing up interest rates. However, the 2008 financial crisis revealed that the inflation-interest rate relation and the framework of monetary policies that are based on this relation must be questioned again.

Let us address one of the well-known and most fundamental equations in macroeconomics and ask how monetary policy advocates the opposite while interest rates and inflation move in the same direction? In other words, why do central banks increase interest rates to curb inflation or reduce interest rates to ensure growth and drive up inflation? Do such moves lead to a success? Certainly not; let me start with this.

The Fisher equation is the basic component in both macroeconomic movements - the Keynesianism and monetarism - that dominate both past and current economic policies. However, these approaches that are opposite each other in many aspects uphold the same argument in a surprising way, saying that the Fisher equation is unstable, when interest rates and inflation are concerned. For instance, let us suppose that a central bank keeps the nominal interest rate stable on a certain level. The Keynesian and monetarist views suggest that in this case, following a small decline or rise in inflation, a deflationary vortex or inflationary spiral emerges over the course of time. Therefore, the central bank must manage interest rates in an active way to avoid these nightmare scenarios. In modern monetary policy, this is done in accordance with the Taylor principle, which argues that the central bank must increase interest rates over 1 percent if inflation rises to 1 percent. Accordingly, when inflation starts rising, the central bank must increase interest rates in a rapid and decisive way or decrease it when it begins falling.

Traditional active interest rate policy, which was practiced in many countries for many years, came to a deadlock after the 2007 financial crisis that started in the United States and spread globally. The following developments revealed an economic picture that was quite the opposite of what both Keynesian and monetarist models expected. With the breakout of the crisis, the U.S. Federal Reserve (Fed) rapidly decreased overnight interest rate - the federal funds rate - and fixed it nearly at zero percent from above 5 percent. The Keynesian model argues that the economy is expected to enter a deflationary vortex in such a case in the following way: The anticipated inflation starts falling with the crisis. However, a nominal interest rate cannot fall further as it is fixed at zero. The Fisher equation suggests that if the anticipated inflation drops when the nominal interest rate is fixed, the real interest rate must rise in this case. As a result of the rise in the real interest rate, the aggregate demand declines further in the economy. So, the anticipated inflation drops again and the real interest rate rises again. At the end of this self-repetitive process, the economy enters a deflation vortex. This expectation of Keynesian models did not come true in the post-crisis months.

The changes in interest rates and inflation that occurred in the post-crisis period cannot be explained by monetarist models, either. As interest rates were near zero in this period, it was understood that traditional monetary policy would run into the ground and an extraordinary practice called quantitative easing (QE) was introduced. Within this framework, the Fed launched quantitative easing in 2008, 2009 and 2011 - as a result of which the Fed's reserves went through a 40-fold upsurge, increasing to $2 trillion from nearly $50 billion in three years. Traditional monetarist models and commentators argue that high inflation, or even hyperinflation, must emerge in the economy as a result of such a rise. This expectation failed too, as inflation maintained its steady trend with a nearly one-point increase in the following months. For more than seven years since 2008, the nominal interest rate has been fixed at zero in the U.S. However, this did not lead to phenomena such as the deflationist vortex and hyperinflation as Keynesian and monetarist models anticipated. A similar case applies to the eurozone, the United Kingdom, Sweden and Switzerland. Moreover, the general price level maintains a relatively stable course in the Japanese economy where the nominal interest rate has hovered around zero for nearly 20 years.

Central banks across the world did not keep nominal interest rate stable for a long time in any period until the 2007 crisis. However, traditional approaches have come into question when it was seen that inflation pursued a stable path after the zero interest rate practice was implemented over the past seven years.

Among new-generation studies, Belaygorod and Dueker's 2009 study and Castelnuovo and Surico's 2010 study estimated the new Keynesian dynamic and stochastic balance models, and found that inflation could rise immediately after an increase in interest rates. These debates in the academy will be reflected by central banks sooner or later. For instance, St. Louis Fed President James Bullard said in 2015 that a fixed interest rate policy is a realistic possibility, and the U.S. might have to revise suppositions regarding the functioning of its monetary policy if low interest rates and low inflation continue. I will continue this important debate in a future column.

Share on Facebook Share on Twitter
Disclaimer: All rights of the published column/article are reserved by Turkuvaz Media Group. The entire column/article cannot be used without special permission even if the source is shown.
However, quoted column/article can be partly used by providing an active link to the quoted news. Please click for details..