As the debate over whether the Federal Reserve will lower interest rates this year continues, an important question has been raised by Unhedged: “Are higher rates inflationary?” While it is true that higher rates may not be inflationary overall, there is a strong case to be made for inflationary effects on specific index components, such as housing. This could be having a larger impact than usual. Additionally, higher rates can imply that inflation is high, which can influence consumer inflation expectations to remain at elevated levels.
The relationship between interest rates and inflation is not always straightforward. Central bankers should not assume a direct correlation between the two or be swayed by the financial market’s narrative that suggests otherwise. The challenge lies in the fact that historically, a decrease in US consumer price inflation from around 3-4% to approximately 2% has rarely been achieved without the occurrence of recessions.
Gradually lowering inflation from its current level of 3.5% will require time for workers and businesses to adjust. In a growing economy, this slow adjustment is a positive sign and not cause for alarm. However, a significant drop in inflation from current levels would likely necessitate a recession or a positive supply shock.
Central bankers are wise to maintain an easing bias as they can respond promptly if growth and inflation increase rapidly. The concept of “opportunistic disinflation,” where central banks wait for a positive supply shock to naturally lower inflation rather than artificially inducing a slowdown, is highly recommended in the current economic climate.
Being proactive in addressing inflation before it becomes a problem is preferable to trying to correct it once it has already escalated. In the event of a recession, there is also the risk that inflation could fall below target levels, making it difficult to adjust monetary policy effectively. This could result in interventions such as quantitative easing being necessary, which should be avoided if possible.
It is essential for central bankers to remain vigilant and prepared to act swiftly in response to changing economic conditions to ensure stability and keep inflation in check.
