Inflationary Interest Rate Increases?

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?

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...

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....

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.

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.

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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.

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.

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:

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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?

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?

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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.

Great explanation PMU! Even I can understand that one.

PMU said:

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

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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.

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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.

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.

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.

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

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 !

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

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.

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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

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.

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).

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.

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