This myth is particularly popular in the business community and in Congress. Members of this school -- sometimes called the interest cost-push school -- insist that high interest rates are inflationary because they raise business costs that firms must recoup by raising their product prices.What is the "particular set" of prices that are affected? Essentially all prices. In an economy like ours before the crisis, with extremely high reliance on credit, a change in interest rates impacts almost everything.
Interest cost-push theorists rarely explore the reasons for higher interest rates. They fail to note that a rise in interest rates unaccompanied by an increase in the ratio of aggregate demand to real aggregate output cannot be inflationary. As a result, they mistake a rise in a particular set of relative prices for a rise in the absolute price level.
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| Additions to Credit Use compared to the Quantity of Money in the Spending Stream Additions to Credit in Use Came to about 10% of M1 in the late 1950s, about 40% in the early '80s, and were about Equal to the Quantity of M1 Money shortly before the financial crisis |
After the crisis it dropped off, but only because our additions to credit use dropped. Not because our accumulated reliance on credit dropped precipitously. After all those years of adding to credit use, and with no direct help from policy after the crisis, we still carry a huge and costly debt that must be paid down. The line on the graph runs low of late because we're not borrowing much these days. That makes our economy slow, but does little to get our existing debts paid down.
That line on the graph plummeted during the Great Recession because quantitative easing vastly increased the quantity of M1 money. But conditions didn't improve because of it, because that money didn't work its way out into the economy. We know this, because we didn't get the worrisome inflation that so many people were predicting ten or twelve years back.
It's all well and good to say a change in interest rates affects only "a particular set" of prices. But the size of that particular set depends on how much we rely on credit.
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Checking my work this morning, I came to this part:
"In an economy like ours before the crisis, with extremely high reliance on credit, a change in interest rates impacts almost everything."
Then I remembered something Kevin Kliesen said in his new paper A Comparison of Fed "Tightening" Episodes since the 1980s. Here's Kliesen, on the tightening of 2004-2006:
"Over this two-year period, encompassing 17 meetings, the FOMC raised its federal funds target rate from 1 percent to 5.25 percent in 25-basis-point increments."
At a time when the quantity of money we use for spending was being boosted by new uses of credit in increments ranging from 60% to 80% of that quantity, the Fed raised interest rates from one percent to five and a quarter. They had 17 chances to think about not doing it, and they did it anyway.
If the increments were always 70%, a 4.25% increase in interest rates would have increased the interest cost of new borrowing by almost 3%: by almost 3% of the quantity of M1 money.
3% may be a bigger number than you think, as Real GDP growth at the time was about 3.5%, and falling.
In the third quarter of 2007 the new use of credit was 104.5% of the quantity of money, so the higher rates translate to a cost increase equal to more than 4.25% of the quantity of money. It is no wonder that, as Kliesen observes, "U.S. economic activity peaked in December 2007." Given the economic conditions of the following ten years, however, "economic activity peaked in December 2007" is one hell of an understatement.
In an economy like ours before the crisis, with extremely high reliance on credit, a change in interest rates impacts almost everything, and impacts it more than even the experts realize.
Or look at the change in debt relative to GDP instead. At the end of 2003, change in debt amounted to 6.9% of GDP. Three years later it was 7.9% of GDP. The average is 7.5% of GDP.
A 4.25% increase in interest rates, 4.25% of 7.5% of GDP, amounts to a cost increase of just under one-third of one percent of GDP. In three years, 1% of GDP. It's a rough calculation, but you get the idea.
Monetary policy, by raising the rate of interest in the 2004-2006 period, caused a quantity of money roughly equal to 0.33% of GDP to move out of the creation of GDP and into the pockets of creditors. That's 0.33% of GDP each year.
Year RGDP % Growth
2004 3.8
2005 3.5
2006 2.9
2007 1.9
2008 -0.1
2009 -2.5
I said: "In an economy like ours before the crisis, with extremely high reliance on credit, a change in interest rates impacts almost everything, and impacts it more than even the experts realize."
Kliesen understates the problem (p.27):
"Actions by the FOMC to raise its short-term interest rate target can adversely affect interest-rate-sensitive sectors of the economy, such as spending on durable goods."
To be sure, the problem grows worse as our reliance on credit (TCMDO/M1SL) grows worse.
See G. Thomas Woodward's Money and the Federal Reserve System: Myth and Reality:
"Interest-based cost theories of inflation are not uncommon. But they are not commonly embraced by economists. Their major shortcoming is ..."
and my post: Woodward: Interest and Inflation.
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