How does raising interest rates help curb inflation?

[chiadam]

Think of interest rates as the price of cash. When they are low, cash is cheap; you need more cash to buy things. When you raise rates, cash is more expensive; you need less cash to buy things.

 

[financeguy]

Just going to throw this one out there as it's something we've been discussing a lot on the trading floors, and it's not quite as black and white as the theoretical arguments posted above. And apologies in advance to anyone who hates Krugman.

When the Fed buys up any asset under the sun, it goes to an investment bank and credits its reserve account with cash in exchange for the assets. Because of the massive size of the Fed purchases, it drives up the prices of these fixed income products and thereby decreases interest rates. That much is obvious. The conventional economic argument then argues that this excess supply of money should cause inflation, and the economy should be jumpstarted by consumers' access to cheap money via low interest rates for borrowers to finance whatever they want to buy (e.g. housing, cars). That's all well and good, and logical, but it's just not what has happened. Inflation hasn't been soaring due to extremely low interest rates and the system being flush with cash. The reason is explained by those bank reserve accounts from the first sentence of this paragraph. Since the beginning of QE, these reserve accounts have just been stockpiling that electronically credited cash. Banks traditionally make money by paying low front end interest rates on deposits and lending out at high back end rates - but if you were a bank and could see that long dated interest rates were artificially low, you might hold off on making a ton of loans until the Fed tapers QE and rates return to normal levels. And that is what we have been seeing. The supply of money accessible to you and me hasn't gone up because the cash has never left the reserve account vault, and therefore this low interest rate environment has not spurred on inflation. Perversely, when the Fed begins to taper its asset purchases and back end rates correct, banks could then start making all those loans, release the ocean of cash into the economy, and then we might have some inflationary issues on our hands. Now all of this isn't meant to say that traditional macroeconomic theory is wrong, it's just to say that because of the way our system works and because we're in a near-zero rate environment, the normal relationship between interest rates and inflation just doesn't hold.

 

[financeguy]

Just going to follow up briefly on this because we're approaching the next stage of the game. The Fed has signaled a tapering of their QE program which will probably begin this September (subject to wiggle room based on macroeconomic data), and so back end rates have screamed higher in anticipation. Additionally, a lot of assets that the market believed were propped up by QE in a hunt for yield around the globe - mainly emerging market assets - sold off sharply. So does this mean that we're in trouble as the supply of money in the real economy increases when banks release cash reserves? Not necessarily, because the Fed has their second tool, raising the benchmark short rate up from 0%, to reign in credit expansion and contract the money supply. They have indicated they won't do that until the market is ready for it. Importantly, they have explained that it is separate from the QE program and won't be done until the QE program is over (the market is pricing this to happen in about 2 years from an eyeballing of the yield curve). Of course, the Fed will have to get their tightening cycle (progression of periodically raising short term interest rates) just right in terms of size and increments to stave off inflation while not being too punitive on the economy. So needless to say, all eyes will be on macroeconomic policy and data in the US in the next couple years even more so than in the last couple years.