The Complex Relationship between Interest Rates and Inflation: Central Bankers Must be Cautious in Their Decisions

The ongoing debate over whether the Federal Reserve will lower interest rates this year has led to an important question being raised by Unhedged: “Are higher rates inflationary?” While higher rates may not be inflationary overall, there is a case to be made for inflationary effects on specific index components, such as housing. Additionally, higher rates can imply that inflation is high, which can influence consumer inflation expectations to remain at elevated levels.

However, it is crucial to recognize that the relationship between interest rates and inflation is not a straightforward one. Central bankers should not assume a direct correlation between the two nor should they 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.

To address this challenge, central bankers must maintain an easing bias and wait for positive supply shocks to naturally lower inflation rather than artificially inducing a slowdown. This concept of “opportunistic disinflation” 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 a 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, 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.

Central bankers should not assume a direct correlation between interest rates and inflation or let themselves be swayed by financial markets’ narrative suggesting otherwise. Historically, decreasing US consumer price inflation from around 3-4%