Interest rates and inflation

The Federal Reserve (and other central banks) has raised interest rates in response to concerns over inflation. The question is whether raising interest rates should slow inflation? I have considerable reservations with the suggestion that raising interest rates alone will stop inflation.

If the inflation was caused by rampant consumer demand and capital investment, raising interest rates could be expected to slow demand because consumers and investors alike have to pay more to service their debts and the additional money spent on servicing debt is not available for other uses. However, rising demand only represents part of the inflation story.

Only part of the current bout of inflation is due to rising global demand for commodities which has driven up the prices of things like industrial metals and energy products. However, there is evidence to suggest that, so far, demand has been relatively inelastic. For example, Alan Greenspan recently commented that there was no evidence to suggest that rising petrol prices had affected consumer demand for petrol.

The the other part of the story behind the inflation numbers is liquidity and the money supply. Central banks around the world have been inceasing the money supply at a rate that has fueled inflation. If the Federal Reserve and other central banks are serious about taming inflation, they will slow the growth in the money supply and tighten liquidity. Of course, tightening liquidity will have other conseqences so they will need to strike a balance between bringing inflation under control and avoiding a recession (or, at least, acheiving a soft landing).