How Interest Rates and Inflation Really Work

[RJG18]

Reducing interest rates (or keeping them permanently low) has the effect of increasing borrowing, which has the effect of putting more money into circulaton to be spent on both consumer purchasing and assets.

This will always prove inflationary in the end, and hence can only ever be temporary.

If it increasing money supply WASN'T inflationary, then you could simply double all of our wealth and make everyone rich by printing twice the amount of cash and handing it out. All this really does of course in this scenario is half the value of the currency. If you and everyone else, say has a £10 note. The bank then prints twice as many notes and gives each person an extra £10 note you now each have £20, but now £20 will only buy you exactly what £10 would (i.e. Prices have doubled).

This is because nominal currency is simpy a representation of wealth, of real things or real resources, be they food, cars, houses, companies, machinery, metal, gold, oil, or whatever.

The available real wealth (resources/assets/products/etc) doesn't actually flex much. If we all become nominally twice as well of (in terms of how much money we have) then we cannot buy twice as much with the money.

Lets say, for example a Porsche costs twice as much to build as a Mondeo in terms of the amount of staff time it takes to design, build and test, and the amount and quality of materials required to make it. Lets say that most of the population can only afford a Mondeo, not a Porsche. Now lets say that low interest rates, easy borrowing and increased money supply means we al have access to twice as much money. We can now all afford to buy Porsches? No. This is a temporary inbalance. The porsche still takes the same amount of resources (staff time and materials) to produce. It still takes the same numbers of man-hours to build, and the same weight of materials. There are suddenly not now double (or any higher multiple) of staff time or materials available to produce all the extra Porsches so we can all have one. Instead the cost of the materials doubles (in nominal terms) and the Porsche employees (and everyone else in the economy) requires twice the nominal salaries in order to do their job while affording the relative costs of living.

So the effect would simply be to half the value of you currency. Which is international monetary terms is rarely a good thing. Hence interest rates will come back up, if they have been low, in order to preserve the value of the currency, ragardless of the effect it has on the percieved values of peoples houses or their garden decking.

The other effect of low interest rates is that it incentivises everyone to borrow money (as this is now cheap and plentiful), and not to save (or to spend their existing savings) as they do not make much profit in interest on their savings, so it hardly seems worth saving. This inbalance of Borrowing to Savings is also a temporary effect of lower interest rates, and is unsustainable. For every Borrower there must be a Lender. When you take out a mortgage at 7% APR, the bank is simply giving you the money from someones Bonds, Savings or Whatever, for which they are paying the original Lender, say, 5% interest, and keeping the 2% difference as the banks own revenue.

However, with less people saving/investing the supply of money available to sell to the borrowers gets ever sqeezed. We can't all be borrowers and none of us lenders. Hence, Interest rates come back up again, above average levels, so that now borrowing is not so attractive as it is expensive to borrow (and to pay off existing debt) but more people save and invest as the returns on their savings are now much better. And after all, they feel they should be saving for a rainy day as the economy will be in "uncertain times" what with interest rates now being higher, job security threatened, and assets that previously held and artificially high value thanks to the increased money supply now falling rapidly in value.

[membrane]

that is the best explanation i've ever read about IR & inflation. Now I realise there is no point just printing money.

Cheers

[Time to raise the rents.]

Thanks for the lesson teach, maybe you could explain why Eurozone rates are sub inflation & the U.S. as well.....

[Guest Private Fraser]

Reducing interest rates (or keeping them permanently low) has the effect of increasing borrowing, which has the effect of putting more money into circulaton to be spent on both consumer purchasing and assets.

This will always prove inflationary in the end, and hence can only ever be temporary.

That is why the BoE must head towards a stable neutral rate.

Savers must be given an incentive to save to prevent the pension timebomb.

In the last few years rates have only been in the borrowers favour, and look at the consequence of that.

Thanks for the lesson teach, maybe you could explain why Eurozone rates are sub inflation & the U.S. as well.....

And they are climbing or will as is expected the Eurozone will begin to raise rates at year end. It appears rates are starting to rise worldwide.

[RJG18]

Thanks for the lesson teach, maybe you could explain why Eurozone rates are sub inflation & the U.S. as well.....

Are you asking why in some areas of the world base rates of interest can be lower than inlfation? There is no reason why a government or central bank(s) cannot temporarily reduce real interest rates to 0% or even into negative levels. (Where the real intest rate, Base Rate less Inlfation, equals zero or less). This can be used to divert a downturn, or stimulate growth. America has had zero or negative real interest rates for a while now, otherwise their economy could have been in severe and present difficult following both the stock market downturns around 2000 and terrorist attacks in 2001.

However this is only temporary. Low interest rates will and have lead to both rising inflation and over-inflated asset prices. Interest rates will then have to rise to prevent this inflation devaluing their currency. Sure it goes out of kilter temporarily, where for a while interest rates are low and inflation is low, but inflation will alway catch up with you (as I've pointed out in my original article). Otherwise we could simply ALL be "real" millionaires.

This is why we are now seeing rapid interest rates rises in USA. And Euroland will follow soon.

[Time to raise the rents.]

Interesting that you say inflation will always catch up. Because as far as I know, central banks and governments aren't in the business of breaking economies to bring things back down to the perceived value of paper money!

That would amount to chasing red herrings.

[Guest Private Fraser]

That would amount to chasing red herrings.

A very valuable fish

[RJG18]

Interesting that you say inflation will always catch up. Because as far as I know, central banks and governments aren't in the business of breaking economies to bring things back down to the perceived value of paper money!

That would amount to chasing red herrings.

You've missed the point. The banks won't act to bring assets back down to match the paper value of the currency. You're reading the cause and effect backwards here.

The assets (houses in this case) have become over-vlaued because the increased money supply made available to people through low interest rates. This is a by-product of the increased money supply. With more money available to chase the same relatively limited supply of property, prices of course rose. (This is by definition a form of inflation, even if it is outside the official inflation measures).

However, the government/banks will increase interest rates, to reduce money supply into the economy to prevent general price rises accross the board (inflation), otherwise teh currency will become devalued. The fact that this reduced money supply will take away the life-blood that is needed to sustain the current prices of over-priced property is merely a by-product of this process. The bank is in no way actively "reducing the value of property to bring it back in line with the nominal value of currency", it is acting to maintain the value of the currency.

It has two options:

1) Increase Interest Rates - reducing money supply, retaining the value of the currency; Indirect Consequence: Property Values Fall.

2) Reduce Interest Rates - increasing money supply, devaluing the currency; Indirect Consequence: Property Values Rise.

Only option 1 is ucrrently acceptable, and is inline with the core remot of the BoE MPC.

[Time to raise the rents.]

Option 2 is the less painful way and is arguably currently in progress in Euroland and the U.S.

Inflating the economy to match the assets rather than deflating the assets to match the economy.

Put it this way, when threatened with recession, the easy ways is often chosen.....

Do you know who it was that first theorised (and later achieved credit for the theory) in the UK that the act of inflation is less painful than deflation?

[Guest Private Fraser]

Only option 1 is currently acceptable, and is inline with the core remot of the BoE MPC.

The right way

Option 2 is the less painful way and is arguably currently in progress in Euroland and the U.S.

The way which suits those with vested interests.

[Time to raise the rents.]

Only option 1 is currently acceptable, and is inline with the core remot of the BoE MPC.

The right way

Option 2 is the less painful way and is arguably currently in progress in Euroland and the U.S.

The way which suits those with vested interests.

Let me tell you something quite scary.....the vested interests have more power than many realise.

[RJG18]

Do you know who it was that first theorised (and later achieved credit for the theory) in the UK that the act of inflation is less painful than deflation?

Absolutely no idea. Taking a blind guess, was it someone like John Maynard Keynes?

Failing that, it was probably some extemist like Marx?

So who was it then?

[RJG18]

Let me tell you something quite scary.....the vested interests have more power than many realise.

I fully agree, so long as we're talking about the 'real' powerful vested interests (Banks) and not less less important vested interests (Estate Agents and chubby women babbling something about small pox vacuums).

However, it is certainly not in the Banks interests for interest rates to remain low indefinately and the consequencial Savings-to-Borrowing inbalance grow.

[Guest Private Fraser]

Let me tell you something quite scary.....the vested interests have more power than many realise.

So the back rooms boys are running the economy, and the BoE are their mouthpiece. You learn something every day.

Must admit not to old to learn.

However, it is certainly not in the Banks interests for interest rates to remain low indefinately and the consequencial Savings-to-Borrowing inbalance grow.

Well said RJG18.

My bank manager telephoned me today asking me to invest in a HI bond they were offering, saying interest rate rises would make it a good bet.

Every rise increases their profits too.

[Time to raise the rents.]

Do you know who it was that first theorised (and later achieved credit for the theory) in the UK that the act of inflation is less painful than deflation?

Absolutely no idea. Taking a blind guess, was it someone like John Maynard Keynes?

Failing that, it was probably some extemist like Marx?

So who was it then?

It was Sir Isaac Newton.

[Time to raise the rents.]

Let me tell you something quite scary.....the vested interests have more power than many realise.

I fully agree, so long as we're talking about the 'real' powerful vested interests (Banks) and not less less important vested interests (Estate Agents and chubby women babbling something about small pox vacuums).

However, it is certainly not in the Banks interests for interest rates to remain low indefinately and the consequencial Savings-to-Borrowing inbalance grow.

Yes I'm talking about those in govt and seats of real power who have a vested interest in the economy moving forward rather than backwards. Not EA's of course.

In time's of crisis they have a habit of changing the rules. A few % of the price of the avg house isn't a time of crisis itself. But a deflationary period is. You only need to look at Japan and see how hard they've tried to get things back on track. Their lack of success probably does confirm a bubble existed.

[London-loser]

Option 2 is the less painful way and is arguably currently in progress in Euroland and the U.S.

Inflating the economy to match the assets rather than deflating the assets to match the economy.

Put it this way, when threatened with recession, the easy ways is often chosen.....

Do you know who it was that first theorised (and later achieved credit for the theory) in the UK that the act of inflation is less painful than deflation?

Hi guys,

Interesting debate.

The big difference is that Euroland is stagnant, with France/German in danger of slipping into recession etc - hence the low/negative real interest rates.

In the US the economy was on the brink of recession/tipped slightly into recession and the low interest rates/negative real rates were introduced to encourage people to spend the country's way out of recession. This seems to have passed and rates are set to rise.

In the UK we are actually running ahead of trend (in terms of economic growth), rather than facing recession at present (sorry Bruno).

Relatively speaking the UK economy is healthier than the US and Europe and so we are seeing quite the opposite - rates going up to choke off inflationary pressures rather than coming down to make people spend.

The UK's economic growth rates are 3-3.5% currently, we are not (yet anyway) even close to fearing recession. If anything the MPC cut rates too much a few years ago (post 9/11 etc) and helped the economy run away, it is now correcting things before inflation starts to build up.

[Guest Private Fraser]

Interesting debate.

The big difference is that Euroland is stagnant, with France/German in danger of slipping into recession etc - hence the low/negative real interest rates.

Leave this with you TTRTR

Yes I'm talking about those in govt and seats of real power who have a vested interest in the economy moving forward rather than backwards.

How great if these these people had been in government and seats of real power during the past 40 years.

[Van]

Great piece, RJG.

Moneytarism and Friedman's helicopters are alive and kicking, except now the cash is dropped purely on housing in the form of mortgages.

Inflation is caused by an increase in the money supply, chasing a finite amount of goods in the economy, hence the purchasing power of money is decreased. The really funny thing is that none of this money is real - it's all securitisation created by the banks who have systematically increased the wider money supply year on year since the 50's. So we are all working harder, chasing illusionary money that doesn't exists, only for the banks to further print more money and decrease the purchasing power of our wages.. a vicious cycle. The BoE really have very limited scope in how they can restrict the commercial banks from creating their own money through the mechanism of cash deposits.

IRs simply determine the cost of borrowing. Rate rises bring future consumption forward when the economy is sluggish - favouring borrowers over savers, and vice versa. What is funny is that most people don't have a clue about what is really important - the real rate of interest, taking inflation into account, hence money illusion abounds.

IMVHO, using IRs as the main tool to control the economy simply doesn't work. It's a one-size-fits-all tool that in reality doesn't cater at all well for anyone. When rates are dropped, the vast majority of consumption brought forward goes on house price inflation, expensive holiday (an import), and other superfluous goods that do nothing to increase the country's wealth and it's ability to pay back that consumption in future years.

Again, the BoE can set the base rate of interest, but they are then powerless as to how the resultant extra borrowing is actually spent. What we really need is less economic red tape and government policies that actually promote real investment in wealth generating businesses.

[Time to raise the rents.]

PF, You'd get more bite from me if you were more specific on what you're trying to say.

If I understand you correctly, here goes, but if you want a real discussion, make some clearer points & I'll discuss.

The big difference is that Euroland is stagnant, with France/German in danger of slipping into recession etc - hence the low/negative real interest rates.

LL hits the nail on the head in his entire post. The UK is not considered at threat from a recession just now, if anything it's considered to be growing too fast. Growth my friend is what produces growing asset values including houses.

However look how hard they're trying in the US & Euroland to make sure that future growth is the order of the day. Current relatively high UK rates are a symptom of there being no immediate problem on the downside. If downside risks appear (including a HP crash), where do you think rates are headed? If upside risks remain, where do you think HP's are headed?

The only mid-term outcome that satisfies both camps in this argument is no or slow HPI for a time and quarantining HP's with low rates (once the growth stops/slows) so the rest of the economy can get on with growing while HP's take a back seat.

And what will the outcome of mid-term growth with low HPI be? An economy that can handle higher rates in the future without tanking.

How great if these these people had been in government and seats of real power during the past 40 years.

There've been mistakes as we all know, but let's be clear here that the last 40 years has overall been a time of growth for the UK and it's international peers.

[Guest wrongmove]

Inflation is caused by an increase in the money supply, chasing a finite amount of goods in the economy, hence the purchasing power of money is decreased.

What effect do you think that Chinese goods and Indian services have had here. It is unlikely that Britain is going to 'use up' the supply. Maybe cheap money now leads to huge debt, rather than inflation. Should BoE be more concerned about debt/savings. Is inflation out of their hands ?

[Van]

What effect do you think that Chinese goods and Indian services have had here. It is unlikely that Britain is going to 'use up' the supply. Maybe cheap money now leads to huge debt, rather than inflation. Should BoE be more concerned about debt/savings. Is inflation out of their hands ?

I've thought about this a lot, and don't really have a conclusion. Trade isn't a new thing, but it is now the norm. Even housing is now traded, insofar as we have Brits buying properties abroad, and foreign investors who have bought whole developments in docklands, etc. Trade and exchange rates is probably the area of economics that in my own mind I understand least.

I think what it will boil down to, like much data we are fed these days, is that the official inflation statistics become more and more meaningless. What is inflation? It's a basket of good that the typical household purchases. It half those goods are experiencing inflation, while the other half is experiencing deflation, the overall figure becomes more meaningless. Statistical distribution showing mean and variance figures are really what is called for.

[London-loser]

If downside risks appear (including a HP crash), where do you think rates are headed? If upside risks remain, where do you think HP's are headed?

TTRTR,

I thought we agreed that a 20% or so correction in house prices really isn't going to be very painful for the UK economy?

I think this can happen without any recession - we are only talking about the average house price getting back to late 2002/early 2003 levels.

I've said before that I think the MPC will only chop interest rates notably if there REALLY is a panic in the housing market... and in this case I don't think the rate cuts will hold the market up (once people's central view on property has fundamentally changed from 'it can only go up' to 'you can lose your shirt very quickly').

[Time to raise the rents.]

IMO a 20% HP correction is only a low risk thing if coupled with a fall in rates, say to match Euro rates (who knows, it might even spark a Euro referendum?).

So the downside risk of a HP crash can be balanced with low rates and probably prevent a recession. But if HP goes off a cliff & rates rise in response to other factors in the economy, Bruno get's his day in the sun.

I think we're still in agreement, but there's many different ways to point out the same thing & it's always worth saying it again when a related topic comes up to prevent the argument from going too one sided.

[London-loser]

TTRTR,

That's interesting.

I think there is 'Bob Hope' and 'no-hope' of us seeing 2% interest rates (Euroland levels) any time soon. The only way I see this happening is if Bruno's view is in danger of coming true.

I don't think this is impossible, but I really don't think it is likely - and I think the housing market would be trashed by then (never mind falls to early 2003 levels).

Remember it was only two months ago when Mervyn King was warning about house prices being at unsustainable levels, people should prepare for the idea that they can fall etc.

Using the Halifax numbers (for the UK as a whole, seasonally adjusted etc) a 20% fall would take the average house price back to its level of about May 2003.

Why do you see this as a high risk for the UK economy?

You must have a pretty bearish view on the UK economy - perhaps driven by the debt levels, MEW etc?