Interest Rate — Inflation Dilemma
By: Simon Hungate
Tags: Interest Rates, Inflation, Economy, Economics, Japan

A very basic economic principle quite simply states that as interest rates decline, inflation tends to increase. This is for many reasons, but most specifically, aggregate demand is composed of Consumer Purchases, Investment, Government Spending, and Net Exports. When interest rates decrease, the cost of borrowing decreases and thus investment increases. The same applies to the famous Phillips curve, which shows the inverse relationship between unemployment and inflation. When unemployment decreases, consumer spending increases, theoretically causing inflation.

It all makes quite a lot of sense, and for many decades, these were the principles used by Central Banks to ensure that inflation never got out of control, and that deflation never became part of daily vocabulary.

However, in recent years, interest rates have remained at extremely low levels in Canada and the US, and yet, inflation remains below the targeted 2%. In Japan and the Euro-Zone, interest rates are sub-zero, and nonetheless, inflation is negligible.

This leaves economists with a real dilemma, and may raise the question, why do we try and maintain a rate of inflation of 2%? Let’s look at why inflation is so important, as well as a couple of theories as to why the usual inverse relationship has seemingly disappeared between the relationship of inflation and interest rates.

Low inflation levels may seem like a positive thing — imagine a world where prices never increased and we always paid $0.25 for movies, just like the olden days. This is far from the reality any economist hopes for. For decades, Japan has struggled with dangerously low inflation levels and has pumped trillions of dollars into the economy to try and drive up inflation. Unfortunately, a mindset has been created in Japan, where consumers are extremely conscious of price rises. Thus, firms cannot raise prices for fear of low demand, and a vicious cycle ensues, where firms then cannot pay their workers more, and the economy never really progresses. That’s a really simple example of why inflation is key in consumer spending.

In a world where prices don’t increase, or worse, decrease, there would be no incentive for consumers to purchase goods; if the price doesn’t increase, or is decreasing, then why would anyone buy goods now instead of a few months, or years down the road?

Take the housing market: if inflation was at 0%, no one would go ahead and purchase a property at that point — they can simply put it off until they find the ideal time. In comparison, with inflation at a healthy 1.5–2.5 percent, they are incentivized to buy a home now instead of paying more later, without inflation spinning out of control. Low inflation also magnifies debt, as it makes it harder for people to pay interest on mortgages and loans. If you are locked in with a certain interest rate, continuing salary increases help lower the burden this interest has on your day to day life. Without inflation and hence little change to salary, this debt plays a much bigger role in the average person’s finances. Finally, low inflation raises worries about stocks, housing and other assets declining in value. This could potentially prompt sell-offs, leading to recession.

Now that we have an understanding of why inflation is important, let’s address the question of why the usual drop in interest rates isn’t prompting inflation. If the answer was clear, we would have two percent inflation currently. Since we obviously can’t get to the bottom of it, let's use Japan as an example, and float out some theories as to why this is happening.

In Japan, the reason why inflation has stayed so low is believed to be because Japanese consumers have become increasingly used to very small changes in prices. When prices increase, they simply do not purchase the product. This makes it impossible for price increases to occur, even with the central bank purchasing extremely high amounts of Japanese assets over the past 10 years (buying assets adds money to the economy, and thus theoretically should drive the economy). It’s important to understand that, in Japan, it wasn’t always this way. Deflation only started in the 1990s because of a stock market crash due to a bubble created by speculating investors driving up the stock prices. The central bank was slow to respond to the crisis, and deflation persisted, continuing to decrease aggregate demand and hence prices. Japanese consumers became used to little to no price increases, and now, it has become extremely hard to get out of the trend. This is one example of how low inflation has persisted in times of low-interest rates.

Much of the rest of the western world, however, does not share the experiences of Japan. So why are Canada, the US and currently, the European Union currently facing comparable issues? The first and most obvious reason is technological growth. One of the major factors that drive inflation is when workers demand higher wages, rising production costs and hence prices. Technology has caused drastic increases in worker productivity, hence offsetting any wage increases occurring in the economy (and then some). This means there are less inflationary pressures on the economy. Technology has also made the production of many goods much much cheaper, like TVs, Washing Machines and Dishwashers (remember, this is all relative to the same valuation of a dollar). This offsets considerable inflation in other sectors like tuition, gasoline and health care. Demographics could also play a role, as aging economies also lead to deflationary wage pressure, resulting in a lack of need for price change.

The other theory, Neo-Fisherism, derived from Fisher’s Relationship, relates low inflation to low nominal interest rates. According to Fisher, the Real Interest Rate = Nominal Interest Rate — Inflation. The idea behind this is that although consumers see the nominal interest on their investment, to get the real interest earned, you have to subtract inflation (money, in general, has become less valuable than before). The central bank controls the nominal interest rate and has kept it low for a long time. Thus Real Interest Rate = Nominal Interest Rate — (expected rate of inflation). Assuming real interest rates remain positive, the expected rate of inflation will be less than the nominal interest rate, which, at around 1.5%, is a very low bar. This prompts low inflation to proliferate under the Fisher Hypothesis.

Changing social, political and economic norms are causing long-held fundamental economic principles to hold less ground. Graphs like the Phillips curve and the fundamental theorems of the relationship between interest rates and inflation are coming into question. The exact cause of low inflation remains unknown, which is part of the beauty of economics; there are so many variables that cannot remain constant, and thus determining what exactly is causing things to happen is impossible. Some ideas include little/no increase in inputs, changing demographics and the Neo-Fisherism ideology. In the future, if inflation doesn’t perk up, there could be major negative economic consequences.