VGSH - How Do Higher Interest Rates Push Inflation Down?

2024-03-07 06:30:00 ET

Summary

• Interest rates have a meaningful impact on the economy by damaging banks and credit markets. This has been quite clear in the last year or so.
• Despite this, there are still some circles of the economic world that claim monetary policy has no impact, or stranger yet, some say higher rates actually push inflation up.
• Higher rates could be stimulative in the short run, but as we’ve clearly seen in the consumption and inflation data, higher rates put downward pressure in the short term.

Following the financial crisis, I was very vocal that lower interest rates and QE would not cause high inflation. This went against the prevailing theory that lower interest rates and more reserves in the banking system could cause a surge in bank lending as lower rates make loans more affordable and more reserves give banks more ability to “multiply” loans. The reason this wasn’t true was because the USA was in a specific type of recession called a balance sheet recession in which households were paying down debts following a huge credit boom. This meant that there was very little demand for debt, and so, increasing the supply of potential loans was like an apple cart salesman increasing the number of apples he sells with the hope that more supply would create its own demand. But the problem was that the demand for apples was structurally low. Further, we now know that reserves have only an indirect linkage to loans. Banks do not “multiply” their reserves because banks, quite literally, cannot multiply their reserves....

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