# Inflationary Interest Rate Increases?



## mollser (8 Nov 2005)

From the Irish Times today:

"While the ECB says there is no evidence so far that high oil prices have triggered knock-on inflationary pressure through big wage demands, it says that it is worried and will change rates if needed to fend off what it calls second round inflation"

What I'm puzzled about is, would rate increases not be inflationary in itself, causing me to have increased mortgage payments and so demanding a pay increase etc, coupled with a knock on effect on businesses increasing their cost of borrowings, thus increasing the prices charged to customers, thus increasing wage demands and so on spiralling out of control.

Is increasing interest rates not inflationary in itself?


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## ClubMan (8 Nov 2005)

I presume the point is that if the price of money (interest rates) is increased then it can help dampen down (often credit fuelled) spending on other items. Increasing interest rates increases the cost of credit but may be done to prevent cheap credit based demand increasing the prices of other goods and services. 

However - macroeconomics was never my strong point so I could be talking rubbish here...


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## JohnBoy (8 Nov 2005)

hi Mollser, Clubman is correct on this. Moreover, many inflation measures strip out the cost of mortgages so it is the so-called underlying inflation that is been targeted. Rate increases will add to certain measures of inflation (via increased mortgage payments) but they (as Clubman has pointed out) can act as a brake on credit growth (amongst other factors) which in turn should dampen not just inflation, but expectations of inflation. If the markets (and the public) believe that interest rate rises will choke-off inflation this should reduce demands for pay rises etc whcih in turn can reduce actual inflation. Kind of a circular argument but quite a powerful one...


BTW - I have never asked my boss for a pay rise because my mortgage payments have increased. I wonder if it would be worth a try....


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## mollser (8 Nov 2005)

Yep, I believe that theory is correct Clubman. But perhaps the reality, in Ireland especially, is that interest rate increases would lead to further public sector benchmarking or even private sector wage demands etc, thus fueling inflation. 

'Aww its not fair, i can't keep up my quality of life' etc etc.


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## ClubMan (8 Nov 2005)

Wha-hey! My secondary school _Economics _teacher would be proud of me! 


			
				mollser said:
			
		

> 'Aww its not fair, i can't keep up my quality of life' etc etc.


Yeah - just remember how difficult it is to maintain several houses and the associated lifestyle as _Pee Flynn _infamously asserted on the _Late Late Show_.


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## Chamar (8 Nov 2005)

Also, theoretically, a rise in interest rates will enable banks to give you better return on deposits so you should be encoraged to save more.


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## ivuernis (8 Nov 2005)

The trend for oil prices will more than likely be a continuos upwards one if Peak Oil (PO) is upon or not far over the hill to use a pun. There are people on either side of the PO debate and I don't want to start such a debate here as it's not the place but if we take PO as a given, say before 2010, it would seem likely that there will be continual inflationary pressure for several years to come thus necessitating continual interest rate rises. Does anyone here see this as a possibility and if so how high do you think interest rates could go in such a scenario?



P.S. For anyone who doesn't know much about Peak Oil, here is a good starting point:


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## Chamar (8 Nov 2005)

ivuernis said:
			
		

> The trend for oil prices will more than likely be a continuos upwards one if peak oil is upon or not far over the hill to use a pun. There are people on either side of the peak oil debate and I don't want to start such a debate here as it's not the place but if we take peak oil as a given say before 2010 it would seem likely that there will be continual inflationary pressure for several years to come thus necessitating continual interest rate rises. Does anyone here see this as a possibility and if so how high do you think interest rates could go in such a scenario?
> 
> 
> 
> P.S. For anyone who doesn't know much about peak oil, here is a good starting point:


 
I'm no expert on this but I think they'll just drill the hell out of the arctic circle and other areas. As well as extracting all they can from Iraq & try to switch from oil to hydrogen or some other energy source.

That'll probably only delay it a few years, especially given the huge increases on the demand for oil that are forecasted. I just wonder will it be the China/India/Brazil who get hit hardest when supply does peak?


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## PMU (8 Nov 2005)

Inflation is concerned with the increase in prices of day-to-day purchases.  Basically, if the supply of day-to-day goods and services matches the supply of money there is no inflation. But if the supply of money increases and the supply of goods and services remains static or does not keep up, consumers just bid up the price of goods and services so you have inflation.  You don’t buy houses every day but you pay for them by mortgages.  So increasing the mortgage rate will not cause increased inflation; in fact it will cut inflation by reducing the amount of money that you have to spend on goods and services. For example, Paul Volcker the head of the Fed before Alan Greenspan eliminated inflation in the States by raising interest rates to 19%.  ‘Second round’ effects are probably a European thing, if centralised wage bargaining allows compensation for inflation or if public servants in secure jobs secure pay increases to ‘compensate’ for inflation. In the US the increase in interest rates was accompanied by an increase in unemployment so no second round effects.


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## ivuernis (8 Nov 2005)

Chamar said:
			
		

> I'm no expert on this but I think they'll just drill the hell out of the arctic circle and other areas. As well as extracting all they can from Iraq & try to switch from oil to hydrogen or some other energy source.
> 
> That'll probably only delay it a few years, especially given the huge increases on the demand for oil that are forecasted. I just wonder will it be the China/India/Brazil who get hit hardest when supply does peak?


 
I don't consider myself an expert either Chamar, but I have read about the subject fairly extensively over the last few years (suffice as to say it's given me plenty of sleepless nights). I would urge you to read the primer in the link I gave and take it from there. You'll then find answers to the questions you posed in your previous post but unfortunately they may not be the most uplifting answers. 

To quickly answer your questions though, most of the world has already been mapped for oil and gas. We know where it (mostly) is and isn't. What's left probably isn't much in comparison to what we've already found and pumped. Most hydrogen produced today is from natural gas (which is also subject to peak and decline like oil). For hydrogen to work we need to use electrolysis but currently it is highly inefficient along with many other obstacles. Everyone will be affected, some more than others, and the western world (North America and Europe) is not in any better position that China, India or Brazil.


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## ClubMan (8 Nov 2005)

Great explanation _PMU_! Even I can understand that one.


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## mollser (8 Nov 2005)

PMU said:
			
		

> In the US the increase in interest rates was accompanied by an increase in unemployment so no second round effects.



be jeebus - hardly a positive!



			
				PMU said:
			
		

> ‘Second round’ effects are probably a European thing, if centralised wage bargaining allows compensation for inflation or if public servants in secure jobs secure pay increases to ‘compensate’ for inflation.



this is exactly what I was getting at - I have a feeling that these second round effects could be VERY prevalent in Ireland and Europe, what with the vocal union leaders here, in France and Germany, who'll strike at the drop of a hat if anything takes a penny or two out of their pocket, and so seek compensation. This takes account of the fact that, even though mortgage costs do not flow into headline inflation rates, it is a very real cost for the average person, and if that person happens to be so unionised, they'll probably take to the streets.


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## Glenbhoy (8 Nov 2005)

*Will* increased interest rates lead to currency appreciation, thus contributing to a decrease in cost of imports?  The downside being that our exports become even more expensive.


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## CCOVICH (8 Nov 2005)

Glenbhoy said:
			
		

> *Will* increased interest rates lead to currency appreciation, thus contributing to a decrease in cost of imports? The downside being that our exports become even more expensive.


 
In theory, yes, but of course it will depend on the currency pairs in question.


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## demoivre (8 Nov 2005)

It's often been argued in Economics that there is never anything better than a second best solution to an economic problem and there are examples given above. Raising interest rates willl reduce inflation ( demand pull  inflation in particular ) because the more we have to pay out on our mortgages the less we will have to spend on everything else hence aggregate demand decreases and inflationary pressure eases. The downside is that the level of investment in an economy varies inversely with interest rates which in turn adversely affects levels of employment. There are many other examples in Economics  of this type of policy conflict - it's not easy to get it spot on , particularly so when you no longer have control of your own monetary policy !


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## tyoung (8 Nov 2005)

So much to comment on , so little time!
 First of all, why bother controlling inflation in the first place? Because it alters peoples' economic and financial behaviour. I would strongly argue that the asset price inflation in the stockmarket in the 90's and in the property market has greatly altered behaviour(for the worst!). See some of the posts on the property investment page. Therefore Central Bank's should target the price of everything money buys(stocks bonds property etc) and not just some narrow index like the "core" CPI.
 Secondly the consensus Kenysian idea that there's some magically correct level of interest rates at which employment will be maximised while inflation is" acceptable" is gradually being seen as nonsense. An economy is much more complicated than this.
Thirdly as stated interest rates are the price  of money. If you manipulate the price of any commodity including money you distort the supply and demand. In order to achieve a targetted interest rate Central banks buy and sell(mostly buy!) shorterm debt securities. Theres no magic here! Interest rate manipulations represent a subsisity taken from savers and given to borrowers in the name of boosting "aggregrate demand".
 Fourthly interest rates will generally be kept below their natural rate. There are more borrowers than lenders so low interest rates are very popular. Politicans with their highly evolved sense of populism constantly pressure central bankers to keep interest rates low. And central bankers are only human.  They want to be loved and feted too.  There are very few Paul Volkers around(NZ's  Bollard  seems to be an exception). So in our 75 year kenysian experiment, interest rates run below their natural rate, we have constant price and asset inflation to the point where it is expected and considered normal. this has reached levels of absurdity. After 9/11 one of the Fed governor , Bob McTier said everything would be OK if we all held hands and went out and bought an SUV.! Perhaps he was being ironic but he stood thousands of years of commonsense on it's head (to cut back and save in times of adversity) in the name of boosting aggregate demand. with negative real interest rates as a come on boy did Americans  take his advice.
 There is no magic about gold as a monetary  base  as many gold bugs seem to believe  but it does impose  a dicipline  that humans lack.
Sorry for the typos
 regards


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## Duplex (8 Nov 2005)

> Perhaps he was being ironic but he stood thousands of years of commonsense on it's head (to cut back and save in times of adversity) in the name of boosting aggregate demand. with negative real interest rates as a come on boy did Americans take his advice.


 


Greenspan et al were terrified of deflation after 9/11 and the dot com bust, having witnessed the asset bubble busting deflationary depression in Japan,  but some think that the Fed left rates too low for too long, causing more bubbles and more debt.


The American current account and trade deficits are colossal and the Japanese, Chinese and Saudis seem to be loosing their appetite for US bonds (T bills) with hedge funds now buying more US debt than any sovereign nation, who these hedge funds are exactly seems to be a bit of a mystery.



But what happens now the US cant keep exporting jobs to low cost economies, (Americans cant just sit there and consume like some monstrous glutton) paying Asians in worthless dollars.



They will have to lower rates again if the present tightening starts to impact the economy (which means consumer spending in the US )  lower rates make the dollar less attractive to foreign investors.



Will Bush look to address the current account deficit with increased taxes, (surprisingly it seems Shrub is looking seriously at removing tax breaks for home owners.) 



Is the debt party over? and who’ll clean up the mess?    This could get nasty


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## kirvos (8 Nov 2005)

Continuing high oil prices could/will trigger next world recession which would eventually lead to a collapse in oil prices to levels less likely to work through the system into  inflation. 
  Back to 'normality' as we knew it, but the interim pain and disruption could be massive, including the collapse of the house asset bubble here, widespread debt problems as equity disappeared from  second properties and PPRs, aggravated by rising interest rates to choke off inflation threats by ECB.
  With Dell already making plans to decamp the country, can other be far behind for the greener and cheaper fields of multi-lingual, educated Eastern Europe outposts?. 
How fares Ireland Inc then? The 1980s would look like a tea party. NOt to worry, the SSIAS will keep the party going for another two years, but after that, all bets might be off.


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## PMU (9 Nov 2005)

Mollser: Of course higher interest rates will cause unemployment (as you have less money to spend on goods and services or on investment), but so will inflation.  Either way you will have unemployment.  But unemployment while unfortunate for the unemployed is not as bad as unemployment coupled with the serious social unrest that followed extended periods of high inflation such as at the end of the Roman empire, in Weimar Germany or in Allende’s Chile.  
But most of what the ECB is saying is nonsense.  Second round increases may cause temporary problems, but all they really do is shift money and life chances from those who are forced to pay (through higher taxes, higher prices or unemployment) to those, such as monopoly industries, monopoly service providers or public service unions, that can extract them.  Second round increases in themselves just redistribute money around in the economy and are unlikely to produce the continuing year-on-year increase in prices that is inflation (unless governments start to print money to pay for them).


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## CoffeeBrew (10 Nov 2005)

ECB said today in its Nov bulletin that it will focus on headline inflation (i.e inflation including energy costs) rather than core inflation (strip out energy, food, alcohol & tobac) .

The justification for this appears to be that high oil prices may be long-term so there is an expectation that core inflation will converge upwards towards headline inflation and they need to cut this off at the pass, so to speak.

Simply put, if the ECB follows through on this it means:
high oil prices = higher interest rates.

[broken link removed]


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## CCOVICH (10 Nov 2005)

CoffeeBrew said:
			
		

> Simply put, if the ECB follows through on this it means:
> high oil prices = higher interest rates.


 
And you'd love that wouldn't you?


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## CoffeeBrew (11 Nov 2005)

Irish savers can love it and Irish borrowers can hate it but that doesn't make much difference. Irish problems will carry as little weight with the ECB if interest rates start to rise as they did when interest rates started to fall.


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## tyoung (12 Nov 2005)

*Great Expectations!*

"unless governments start to print money to pay for them"
Governments do not print money. they raise money to pay for programmes either through taxes or borrowing.  Either way there is no increase in the money supply.  It is only when  a central bank buys securities(usually shortterm govt. debt)  with new reserves that the money supply in the banking system is increased. This happens under the guise of "monetary operations".  The Irish central bank issues a very detailed monthly update including information on monetary operations.
  The best example of inflationary expectations is in the asset markets. About 1999 it was a widely held view that, since stocks had outperformed in the longrun, one should just buy stocks regardless of price. Historically the rise in stock prices is in large measure due to inflation so this view certainly represented at least in part an inflationary expectation. Subsequent performance has shown that at least in the short to medium term this may not be true.
  Today of course it's the property market that has everybody enthralled. I would regard the rise in property prices as completely due to inflation. Everybody knows that bricks and mortar are the best investment so even if prices are high you should still buy and of course rent is dead money.
Talk about inflationary expectations!


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## joe sod (13 Nov 2005)

"First of all, why bother controlling inflation in the first place? Because it alters peoples' economic and financial behaviour. I would strongly argue that the asset price inflation in the stockmarket in the 90's and in the property market has greatly altered behaviour(for the worst!). See some of the posts on the property investment page. Therefore Central Bank's should target the price of everything money buys(stocks bonds property etc) and not just some narrow index like the "core" CPI."

This is an excellent point and is actually the crucial issue in the world economy since 1993. The central bank's only concentrate on a small basket of groceries and ignore the inflation in  financial assets and property thereby ignoring the destination of most of the the excess liquidity they have created. They then tell us inflation is under control ignoring the ever growing elephant in the bedroom. However the danger is now very real that the inflation in financial assets and property will switch to this small basket of groceries the central banks examine so much.


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## CoffeeBrew (18 Nov 2005)

Trichet appears to be sending one of his clearer messages about an ECB rate rise on December 1st.

Is he bluffin' or wha ?



> After two years and a half of maintaining interest rates at a level that is exceptionally and historically low, I consider that the Governing Council is ready to take the decision to move interest rates and modestly augment the present level of intervention rates in order to take into account the level of risks to price stability.
> 
> We would withdraw some of the accommodation that is in the present monetary policy stance while this policy will remain accommodative


 
http://news.ft.com/cms/s/8c3bc38c-5840-11da-90dd-0000779e2340.html


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