Most economists consider interest rates and inflation to be inversely proportional. When real interest rates are low, periods of high inflation should occur and vice-versa. With this said, inflation in the UK has averaged a meagre 2% between 2010-19, whilst interest rates have stood at record lows. This pales in comparison with the 1990s, which experienced similar levels of inflation with higher interest rates. This calls into question whether low interest rates actually induce higher inflation, given that this theory has been detached from reality during the past decade.
A negative correlation
The theory of a negative correlation between inflation and interest rates makes sense logically. When the Central Bank increases real interest rates through open market operations and the bank rate, this should reduce borrowing as it becomes more expensive. Reductions in spending ensue, leading to the velocity of money slowing down as more money is kept in savings. Lower demand should lower prices, causing lower inflation.
The converse can be said for lower interest rates. As borrowing becomes cheaper and the amount of interest paid into savings accounts decreases, consumers and businesses alike are incentivised to invest and or purchase goods. This increases the demand for products, resulting in higher prices and increased inflation.
This phenomenon was witnessed in the late 1970s, early 1980s, as out of control inflation prompted sharp hikes in the bank rate, resulting in real interest rates increasing accordingly. What followed was a gradual decrease in the inflation rate falling from a peak of 16.4% in 1980 to 3% by 1986.
The Neo-Fisherian Theory
To explain the combination of low interest rates and low inflation, the Neo-Fisherian theory has gained prominence across intellectuals and economists alike. The theory states that there is a positive correlation between interest rates and inflation. As the central bank raises interest rates, higher inflation should ensue. This is a reversal of the standard expectation of inflation-to-interest rates, thus dictating that if a Central Bank wants inflation to increase, they should increase their nominal target interest rate. The logic follows that a reduction in interest rates results in lower borrowing costs for businesses to invest in their productive capabilities. This allows them to charge lower prices for their products since the amount required for debt repayment is reduced.
This can also be explained through the equation: Nominal rate = Real interest rate + Inflation rate. Suppose a Central Bank raises its bank rate by 1%, using other monetary tools such as OMO to ensure this. According to conventional wisdom, real interest rates should trend towards the bank rate, thus affecting economic activity such as unemployment rates and GDP. However, economists generally agree that the effects of changes to the nominal interest rates on these activities dissipate in the long run. Therefore, over many years, an increase in the nominal interest rate will no effect on the real interest rate and thus, according to the equation, an increase in inflation must follow.
The Neo-Fisherian theory explains the low-inflation, low-interest-rate trap that has plagued Japan. As interest rates reach 0%, there becomes no measure that can induce inflation, as the lower bound on the nominal bank rate is zero. This is because negative interest rates would in theory prompt immediate withdrawals from commercial banks due to the negative interest that customers would receive in their savings accounts. In Japan, interest rates have stood at below 1% since the late 1990s yet the average inflation rate has been around 0% since the mid-1990s. The Bank of Japan has an inflation target of 2%, however, this appears to be unachievable.
Many European Central Banks have joined the Bank of Japan in the low-inflation-policy-trap club during the past decade. New notable members include the likes of Swedish Riksbank who had a nominal bank rate of -0.5% and inflation at 0.79%, the ECB with inflation at -0.22% despite a bank rate of -0.34%, the Bank of England with interest rates at 0.47% and inflation at 0.30%, and the Swiss Central Bank who had their bank rate at -0.73% and inflation at -0.35%. All these figures were of 2016, however, these are not too dissimilar to what was experienced in the years that followed.
This same theory dictates that Quantitative Easing is lacklustre and has no impact on inflation rates. Introduced by Central Banks particularly in Europe during the midst of the Great Recession of 2008, the aim was to pump liquidity into the financial markets to induce inflation. This continued throughout the decade, with the ECB stepping up its QE program in 2016, after their attempts to promote inflation had failed.
The Neo-Fisherian theory provides an explanation for the low inflation rates experienced in Europe and the US post-recession. Given the higher inflation rates being witnessed currently in 2021, it would follow that fiscal policy has much bigger on inflation than monetary policy, given the amount of fiscal stimulus introduced by governments following the coronavirus outbreak. As Western Central Banks fail to escape the low-inflation-policy trap, a turn towards Neo-Fisherian monetary policy may be a solution to the seemingly permanent low levels of inflation.