Raising Interest Rates Does Not Counter Inflation

According to minutes from the US Federal Reserve’s April meeting, a majority of officials thought that higher interest rates may become necessary to combat a resurgent inflation. According to the minutes, a majority of the participants highlighted that “some policy firming” would likely become appropriate if inflation were to continue to run persistently above the Fed’s 2 percent target.

But would a higher interest rate stance counter inflation? The key here is the definition of inflation.

Defining Inflation

To form a definition, it is helpful to go back, if possible, to when the subject of investigation emerged. Historically, inflation originated when a country’s ruler such as the king would force his citizens to give him all of their gold coins under the pretext that a new gold coin would replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this, Rothbard wrote, 

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks”, but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.

Because of the dilution of the gold coins, the ruler could now mint a greater number of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a gold alloy coin. The artificial increase in the number of coins (i.e., the money supply) brought about by this debasement of gold coins is what inflation is all about—artificial increases in the money supply. The subject matter of inflation is misappropriation. On this Mises wrote,

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business.

According to much popular thinking, however, inflation is about increases in the prices of goods and services, as depicted by the consumer price index (CPI). In this way of thinking an increase in the demand for goods and services for a given supply causes general increases in the CPI. Hence, on this logic, a decrease in the demand for a given supply will reduce the increases in the CPI. In this framework, an increase in interest rates is likely to weaken the demand and, consequently, weaken the rate of inflation as described by the CPI.

Inflation: The Exchange of Nothing for Something

By means of money, individuals exchange goods and services for money and then money is exchanged for other goods and services. This means that something is exchanged for something else—a voluntary, value-for-value exchange.

When money emerges through inflation and employed in trade, nothing is exchanged for it. When the inflated money is exchanged for goods and services, we have a situation where no goods and services are exchanged for goods and services—that is nothing is exchanged for something.

It is the same outcome when the counterfeiter uses the counterfeit money to obtain goods and services. The counterfeiter produced no goods and services. All that he produced is the counterfeit money that he can employ in diverting to himself goods and services from individuals that have produced these goods and services.

High Interest Rates Cannot Solve the Problem

Can a higher interest rate stance by the central bank undo the damage of the previous low interest rate policy? No, the misallocation of resources as a result of the low-interest rate policy cannot be reversed by a tighter stance. A tighter interest rate stance—while likely to undermine activities that emerged on the back of inflationary increases in money supply—is also likely to generate various distortions thereby inflicting damage to wealth-generators. 

A tighter stance is still intervention by the central bank and, in this sense, it does not result in the allocation of resources in line with consumers’ priorities. According to Percy L. Greaves,

Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

High Interest Rate Policy versus the Closure of Monetary Loopholes 

Let us contrast a high interest rate policy to counter general increases in prices, erroneously labeled as “inflation,” with a policy that closes the loopholes of the money supply expansion. (For instance, the central bank is prohibited from purchasing assets and thus expanding its balance sheet). The policy of curbing money supply increases will undermine bubble activities (i.e., activities that emerged from the previous increases in money supply). This is because it will arrest the diversion of wealth from wealth-generators to bubble activities.

Such a policy is great news for wealth-generators since now less wealth is taken from them. This, in turn, is likely to result in the expansion of productive wealth. This expansion, in turn, is likely to shorten the period of the economic slump and also make the slump less severe. By employing an erroneous definition of inflation, Fed policymakers end up attacking the symptoms rather than the causes of inflation. As a result, they are making things much worse.

Conclusion

A higher interest rate stance by the central bank inflicts damage not only to bubble activities but also wealth-generating activities. This only prolongs an economic slump. If the central bank were to focus on the true inflation, which is increases in the money supply, the effects of curbing the monetary growth rate will be the removal of the bubble activities and the strengthening of wealth-producers. Consequently, this is likely to shorten the period of the recession and also make it milder.