Do High Interest Rates Reduce Inflation? A Test of Monetary Faith

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They did not mind stating apparently opposed truths;
they knew that they could give to men a higher truth,
in which the contradictories became two sides of the same truth.

Rev. Stopford A. Brooke, 1872

Whenever inflation rears its head, the call soon comes to raise interest rates. The rationale is simple. Higher interest rates put a damper on the supply of money. And this monetary clamp slows inflation.

It’s so intuitive that it must be true.

Or is it?


As the Reverend Brooke observes, it takes a person of true conviction to ignore apparent contradictions. As such, this post is designed to test your monetary faith.

According to monetary orthodoxy, higher interest rates reduce inflation. Yet the evidence demonstrates that the opposite is true: higher interest rates are associated with higher inflation.

With this evidence in mind, I invite you to read on. Put your monetary faith to the fire and see if it can survive.

In the quantity of money we believe

Economics has many high priests. But when it comes to the supply of money, there is but one true prophet. His name is Milton Friedman. Beginning in the 1940s, Friedman made waves by proclaiming that many of society’s problems boiled down to the mismanagement of the money supply.

True, some of Friedman’s colleagues balked at this bold reduction. Economist Robert Solow, for example, could barely contain his indignation. “Everything reminds Milton of the money supply,” he complained. “Well, everything reminds me of sex, but I keep it out of the paper.”

Critics aside, there is one area where Friedman’s ideas reign virtually unchallenged: inflation. According to Friedman, inflation is caused by an oversupply of money. His theory (or rather, the theory he popularized) starts with an accounting definition that relates the quantity of money, M, to the average price level, P:

\displaystyle MV = PT

So far, we’re dealing with a truism. By definition, the left side of our formula is equivalent to the right side. However, things get more interesting when we introduce cause and effect. According to Friedman, causation goes from left to right. Too much money, M, induces a rise in prices, P. Inflation!

\displaystyle M \longrightarrow P

Now, you’ll notice that I’ve dropped the terms V and T. (We’ll come back to them in a moment, as they will test our monetary faith.) For now, just marvel at the simplicity of our theory. To control inflation, all we must do is regulate the money supply.

That’s where interest rates come in.

Interest rates, economists observe, affect people’s willingness to borrow money. Why? Because when interest rates rise, the cost of servicing debt increases. And in the face of this rising cost, a rational person will borrow less money. Continuing the story, it turns out that borrowing is the main way that new money is created. Putting it all together, higher interest rates ought to slow the creation of money, and thus reduce inflation. QED.

Doubts among the priesthood

Unfortunately, while Friedman’s theory of monetary regulation is widely accepted, some economists still profess doubts. For example, in 2004, Federal Reserve governor Ben Bernanke admitted that monetary policy is less than an exact science. According to Bernanke, controlling the money supply is like driving a dilapidated car. If you happen to arrive at your destination, it’s mostly by luck:

[I]f making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.

Diving a bit deeper, it seems that Bernanke had good reason to question his faith. To see why, let’s return to our canonical equation:

\displaystyle MV = PT

Continuing Bernanke’s vehicle analogy, imagine that the economy is our car and interest rates are the brake. When we hike the rate of interest, we press the brake on the money supply (M). If all goes well, prices (P) will stop growing. Inflation solved!

Or not.

As Bernanke alludes, inflation reduction is not guaranteed. For example, when we hit the monetary brakes, we may find that instead of manipulating prices (P), we kill the growth of T. That’s not good. You see, T is the ‘real’ value of all monetary transactions — basically an expansive version of ‘real’ GDP. When we kill T, we shut off the economic growth engine. Doing so tends to make monetary managers unpopular.

There is also the problem of V — the ‘velocity’ of money. (In simple terms, this is the rate that money changes hands.) When we manipulate the money supply, we assume a direct brake line to prices. But it’s possible that movement in V will put slack in our brake cable, sending us screaming through a red light.

And if that’s not enough, there is the more dire problem of the supply of money itself. We assume that raising interest rates will slow the growth of the money supply. But as you will see, when we hold our faith to the empirical fire, it bursts into flames.

This is the problem at hand. There is no evidence that monetary orthodoxy is correct. And yet when faced with this contradiction, our faith must endure.

Some basic science

If our empirical journey is to be a true trial of faith, it must inflict sufficient pain. To that end, it’s worth reviewing some basic science.

Here’s the problem. If you are trained in economics, the evidence that I’m about to show you may not evoke doubt. Indeed, some members of the economics profession will stare at this data and conclude that it confirms their monetary faith.1 Of course, faith retention is our ultimate goal. But we want the path to be difficult, otherwise the trial is a sham.

(Any fool can have faith when ignorant. Only the wise can maintain belief in the face of overwhelming contradiction.)

To ensure that the empirical evidence induces sufficient doubt, I will start my foray into monetary policy with some basic science of regulation. We begin in the abstract. Suppose that substance A regulates substance B. This regulation can have two directions. If an increase in A leads to a reduction in B, we say that A ‘down-regulates’ B. Alternatively, if an increase in A prompts a rise in B, we say that A ‘up-regulates’ B.

Returning to economics, faith dictates that interest rates down-regulate inflation. But before we get to the monetary data, let’s set the stage. Let’s observe what actual down-regulation looks like. And let’s contrast this evidence with the pattern of up-regulation.

Down-regulation: Insulin and blood sugar

Over millions of years, animals have evolved sophisticated ways of keeping their body chemistry in a stable state — what scientists call ‘homeostasis’. While the process is complex, the individual ingredients are fairly simple.

The working of insulin is a good example. Insulin is a hormone that down-regulates blood sugar (glucose). It’s effect is easy to observe. When we inject insulin into the body, blood sugar levels drop.

Figure 1 shows an example. Here, a scientist has injected a rabbit with insulin. After the injection, the rabbit’s serum insulin levels spike and fall (blue curve). In response, the rabbit’s glucose levels drop and then rise (red curve). It’s a negative correlation, indicative of down-regulation.

Figure 1: Insulin down-regulates blood sugar. This figure shows what happens when a rabbit is injected with insulin. After the injection (at time zero), the rabbit’s serum insulin levels rise and fall (blue). In response, the rabbit’s blood glucose levels fall and then rise (red). It is a simple example of down-regulation. Data is from Kang and Singh (2005).

Up-regulation: CO2 and the Earth’s temperature

Turning to up-regulation, the relation between carbon dioxide and climate change is top of mind. According to NASA scientist James Hansen, CO2 is the “principal determinant of Earth’s climate state, the radiative ‘control knob’ that sets global mean temperature”. In other words, CO2 up-regulates the Earth’s temperature.

On this fact, the evidence is compelling. Figure 2 shows the long-term relation between carbon dioxide concentrate (in the atmosphere) and the Earth’s average temperature. Unsurprisingly, the coupling is tight. When CO2 concentration increases, so does temperature.

Figure 2: Carbon dioxide up-regulates the Earth’s temperature. This figure shows estimates for the long-term coupling between atmospheric CO2 concentration and the Earth’s average temperature. (Temperature is measured in terms of the deviation from the average over the last 1000 years.) Both estimates come from Antarctic ice cores. CO2 data is from Lüthi et al (2008) and can be downloaded here. Temperature data is from Jouzel et al (2007), and can be downloaded here. Note that I’ve averaged both series over 2000-year intervals.

Looking at the paleo-climate data, it’s worth commenting on how climate skepticism has played out. For the most part, skeptics do not dispute the coupling between CO2 and temperature. (The evidence is simply too strong.) Instead, they imagine a Rube-Goldberg-type mechanism that drives the climate, while somehow pulling CO2 along for the ride. By imagining this mechanism, skeptics rescue their faith that the current bout of climate change is ‘natural’ … i.e. not human-induced.

Here, then, is the road ahead. Notice that not even the boldest climate skeptic looks at the evidence in Figure 2 and concludes that CO2 down-regulates the Earth’s temperature. But for the economic faithful, that is the task at hand. Monetary orthodoxy dictates that interest rates down-regulate inflation. Yet when we look at the data, we see nothing but up-regulation.

Can our faith survive this clash?

A trial of faith

Now that we’ve reviewed the science of regulation, let’s outline your task. Your goal is to stare at the on-coming evidence while keeping faith that higher interest rates reduce inflation.

Your trial will have two main components:

Trial 1: (Not) maintaining the money supply. I will show you evidence that higher interest rates are associated with a faster expansion of the money supply. In the face of this evidence, you must keep faith that higher interest rates slow the growth of the money supply.

Trial 2: (Not) reducing inflation. I will show you evidence that higher interest rates are associated with higher inflation. Your goal is to keep faith that the opposite is true — raising interest rates ‘reduces’ inflation.

Before we proceed, let’s pause to discuss methods. All of my data comes from the World Bank database (which is free to access). The data covers most of the world’s countries, observed over the years 1960 to 2021. (Note that the exact coverage varies by country).

And with that, let’s jump into our dilapidated monetary car and have faith that we’ll arrive at our destination with life and limbs intact.

Trial 1: Interest rates and the supply of money

According to orthodoxy, inflation is a problem of ‘too much money chasing too few goods’. As such, the best way to manage inflation is to regulate the supply of money using the knob of interest rates.

The reasoning is straightforward.

If I have a fixed budget for interest payments, it follows that when interest rates climb, I can carry less debt. And since less debt means less money gets created, ceteris paribus (other things being equal), raising interest rates should either: (a) lower the supply of money; or (b) slow its growth.

That’s the theory. In the real world, it seems that both outcomes fail to materialize. Instead, higher interest rates are associated with faster monetary expansion. Figure 3 runs the numbers.

Here, I’ve taken all the countries in the World Bank database and plotted their lending interest rates (horizontal axis) against the annual growth of their local money supply (vertical axis). To show the trend, I’ve put the raw data into bins. Each blue point represents the midpoint of an interest-rate bin. Within each bin, I then measure the median growth rate of the money supply (blue line). The shaded region shows the middle 50% of money-supply growth rates.

Figure 3: Interest rates and the growth of the money supply — the pattern across countries. Looking at international data, this figure compares national lending interest rates with the annual growth of the local money supply within each country. To measure the average trend, I put interest rates into size bins. Each blue point indicates the midpoint of a bin. Within each interest-rate bin, I then measure the range of monetary growth. The blue line indicates the median growth rate within each bin. The shaded region shows the middle 50% of the growth-rate data (the 25th to 75th to percentiles). Note that both axes use a logarithmic scale. [Sources and methods]

Looking Figure 3, you might think that there’s a mistake. It seems that interest rates go as high as 200%. Surely that’s an error?

Actually, no.

The World Bank database is quite clear that triple-digit interest rates exist. For example, in 1992, Nicaragua had interest rates north of 450%. And in 1994, Ukraine experienced interest rates of about 250%. A year later, Angola had interest rates above 200%. (I could go on.) Of course, we can quibble with the measurements behind these numbers. (Sampling error is always possible). But what seems clear is that interest rates can get absurdly high.

Now according to orthodoxy, these extreme interest rates should be money-supply killers. But if that were true, the trend in Figure 3 would slope downward (meaning higher interest rates slow the growth of the money supply.) However, the trend slopes upward. In other words, higher interest rates are associated with a faster expansion of the money supply.

Something is not right.

But before we lose our faith in monetary theory, we should make sure that the evidence is sound. To that end, let’s turn to Figure 4. Here, I’ve take the interest-rate and money-supply data and measured the trend within countries. To do that, I take each country with relevant data and then calculate the correlation between the lending interest rate and the growth rate of the local money supply. The histogram shows the distribution of correlations across all countries.

Monetary orthodoxy predicts that the correlation should be negative, meaning higher interest rates slow the growth of the money supply. On that front, we do find some countries with a negative correlation (red bars). But they are in the minority. For the vast majority of countries (about 77%, as shown by the blue bars), the correlation is positive. In other words, the norm is that higher interest rates are associated with a faster expansion of the money supply.

Figure 4: Interest rates and the growth of the money supply — the correlation within countries. This figure analyzes the within-country connection between lending interest rates and the local growth of the money supply. The analysis works as follows. For every country with ten or more years of money-interest data in the World Bank database, I calculate the correlation between the money-supply growth rate and the interest rate. The histogram then shows the distribution of correlations. In this sample, 29 countries have a negative correlation (red). The other 103 countries have a positive correlation (blue). So it seems that within most countries, higher interest rates lead to a faster growth of the money supply. [Sources and methods]

A heretical explanation

Looking at Figures 3 and 4, the evidence soundly contradicts monetary orthodoxy. Higher interest rates are associated with a faster expansion of the money supply.

Now, in the face of this evidence, your goal is to keep the monetary faith. But my goal is to hold your faith to the fire. With that in mind, let’s fan the flames by turning to the writings of an economic heretic.

In his article ‘Do Interest Rate Hikes Worsen Inflation?’ Tim Di Muzio claims that there is good reason for monetary orthodoxy to be wrong. The problem boils down to the ceteris paribus clause — the assumption that when we raise interest rates, nothing else changes. To restate orthodox reasoning, if I have a fixed budget to spend on servicing my debt, then it follows that when interest rates rise, I’ll borrow less money. But what if my debt-servicing budget is not fixed? Then orthodoxy breaks down.

In the real world, Di Muzio observes, businesses don’t need to reduce borrowing in the face of higher interest rates. Why? Because when interest expenses increase, businesses can respond by trying to raise their income. In other words, businesses can maintain their debt levels by passing their greater debt-servicing costs along to customers.

Let’s lay out the consequences of this heretical thinking. If businesses practice ‘cost-plus’ pricing — meaning they tack a fixed markup onto their current costs — then raising interest rates ought to stimulate inflation.

What’s frightening is that this simple reasoning is consistent with the monetary evidence in Figures 3 and 4. And it is also consistent with the evidence to come. Hold on to your faith. The ride is about to get bumpy.

Trial 2: Interest rates and inflation

According to economic canon, inflation regulation has two parts. First, we raise interest rates, which slows the growth of the money supply. Second, the induced scarcity of money slows inflation.

Ultimately, it is the inflation reduction that is sacred. Regardless of whether the money supply responds the way it should (it doesn’t), when interest rates rise, inflation must decrease. It is known.

And yet the evidence tests our faith.

Let’s look at it now. Figure 5 plots the international trend between lending interest rates (within countries) and annual inflation rates. According to orthodoxy, we ought to see a downward-sloping line (meaning higher interest rates reduce inflation). But we see the opposite. As interest rates grow, it seem that inflation responds by … increasing.

Figure 5: Interest rates and the annual rate of inflation — the pattern across countries. This figure analyzes the international relation between the inflation rate (within countries) and the lending rate of interest. To show the average trend, I put inflation rates into bins, plotted on the horizontal axis. The blue point indicates the midpoint of the bin. On the vertical axis, I then plot the range of inflation rates (within each bin). The blue line shows the median inflation rate. The shaded region indicates the middle 50% of the inflation data. Note that both axes use a logarithmic scale. [Sources and methods]

While this international evidence is troubling, let’s not lose faith. If we look at the pattern within countries, perhaps we can rescue monetary orthodoxy. To that end, let’s study Figure 6.

Here, I’ve taken each country in the World Bank database (with the relevant data) and measured the correlation between the annual inflation rate and the lending rate of interest. The histogram shows the distribution of within-country correlations. Again, the gods toy with our faith. In a few dozen countries (red), the interest-rate-inflation correlation is negative, as expected. But for the vast majority of countries — about 82% — the interest-rate-inflation correlation is positive. In other words, when interest rates get hiked, the norm is for inflation to increase.

Figure 6: Interest rates and the annual rate of inflation — the correlation within countries. The figure analyzes the within-country correlation between lending interest rates and the annual rate of inflation. The steps are as follows. I start by selecting all countries in the World Bank database with ten or more years of interest-rate-inflation data. Within each country, I then measure the correlation between the rate of interest and the annual rate of inflation. The histogram then plots the distribution of within-country correlations. Red bars indicate a negative correlation. Blue bars indicate a positive correlation. [Sources and methods]

Rescued by dynamics?

At this point, we may need a deus ex machina to rescue monetary orthodoxy. But before that, let’s try one more trick for torturing the data. Perhaps dynamics can rescue us.

So far, I’ve compared interest rates to the rate of inflation. The results were difficult to swallow. But maybe if we look at rates of change, better evidence will show its face.

With annual change in mind, let’s look at Figure 7. Here, I’ve plotted the international pattern between the annual change in lending interest rates and the annual change in inflation. According to monetary orthodoxy, we should see a downward trend. In other words, interest-rate hikes should prompt a decline in inflation. But instead, we see the opposite. When interest rates rise, so does inflation.

Figure 7: The annual change in interest rates vs. the annual change in inflation — the pattern across countries. This figure analyzes the international relation between the annual change in lending interest rates and the annual change in inflation. To illustrate the trend, I place interest-rate changes into bins, plotted on the horizontal axis. The blue points indicate the midpoint of the bin. (Note that the size of the bins increases with the absolute value of interest-rate change. The goal here is to account for the spread in the data. Most interest-rate changes are small, but a few are quite large.) Within each bin, I then measure the range of inflation-rate change. The blue line shows the median change. The shaded region indicates the middle 50% of the data. [Sources and methods]

Admittedly, the dynamics data has failed to confess. But before we search for explanations, let’s look at the pattern within countries. Figure 8 shows the data.

Here, I’ve analyzed the within-country correlation between the annual change in interest rates and the annual change in inflation. The histogram shows the distribution of within-country correlations. According to orthodoxy, the correlations should be mostly negative (indicated by red bars). However, we find the opposite. In about 68% of countries (shown in blue), changes in interest rates correlate positively with changes in the inflation.

Figure 8: The annual change in interest rates vs. the annual change in inflation — the correlation within countries. This figure analyzes the within-country connection between interest rate changes and changes in inflation. I start with all countries in the World Bank database with ten or more years of interest rate and inflation data. Within each country, I then measure the correlation between the annual change in the lending interest rate, and the annual change in inflation. The histogram then shows the distribution of correlations. Countries with a negative correlation are shown in red. Those with a positive correlation are shown in blue. [Sources and methods]

A post mortem

At this point, your faith in monetary orthodoxy should be shaken. According to canon, higher interest rates slow the growth of the money supply, and thus reduce inflation. And yet, when we look at the evidence, there is no sign of this pattern. Instead, higher interest rates are associated with both a faster expansion of the money supply, and higher rates of inflation.

Now, in the face of this falsifying evidence, there is a way to resurrect our monetary faith. But before we get to it, let’s turn up the pain dial one more notch.

How should we interpret the fact that higher interest rates are associated with higher inflation? The least painful option is to suppose that monetary policy is well-intentioned yet toothless. In other words, policy-makers consistently respond to higher inflation with higher interest rates. And yet equally consistently, these rate hikes fail to do their job.

A more incendiary possibility is that monetary orthodoxy does the opposite of what it intends. As heretic Tim Di Muzio observes, if businesses practice cost-plus pricing (tacking a fixed markup onto existing costs), then higher interest rates should actually stoke inflation. Blasphemy, yes. But the idea is supported by the evidence.

In distortions we trust

At this point, our monetary faith is inches from the fire, about to be engulfed by flames. Can we rescue it? That depends on our willingness to engage in magical thinking.

I, for one, have adopted the following solution. Monetary orthodoxy is true by definition. Interest rates everywhere and always down-regulate inflation. It’s just that in our imperfect world, there are ubiquitous distortions that hide this truth.

Think of it this way. When we step into our monetary-policy car, we are climbing into a vehicle that appears dilapidated. Worse, the car usually takes us to the wrong destination. But in the face of this failure, we have faith. In some invisible higher plane, our car is pristine.

In other words, by definition, monetary policy works the way it should. It’s just that we can never observe this canonical outcome, for it is hidden by a barrage of distortions. And yet we have faith. We have faith that the plane of economic truth is there, waiting to be imagined.

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Sources and methods

All monetary data is from the World Bank as follows:

  • inflation rates: series FP.CPI.TOTL.ZG — inflation consumer prices (annual %)
  • interest rates: series FR.INR.LEND — lending interest rate (%)
  • money supply: series FM.LBL.BMNY.CN — broad money (current local currency unit)


  1. The astrophysicist Stacy McGaugh observes that this empirical reversal is a common method ‘explaining’ evidence that contradicts your theory. To escape from an empirical cul-de-sac, simply reverse the obvious conclusion:

    [T]here is no result so obvious that someone won’t claim the exact opposite. Indeed, the more obvious the result, the louder the claim to contradict it.

    Given that the data contridicts monetary canon, brazen reversal of the obvious should be part of every economists’ faith-keeping playbook.↩︎

Further reading

Di Muzio, T. (2022). Do interest rate hikes worsen inflation? Strange Matters.

Hansen, J., Sato, M., Hearty, P., Ruedy, R., Kelley, M., Masson-Delmotte, V., et al.others. (2016). Ice melt, sea level rise and superstorms: Evidence from paleoclimate data, climate modeling, and modern observations that 2 c global warming could be dangerous. Atmospheric Chemistry and Physics, 16(6), 3761–3812.


  1. Nice work as usual. But (sorry this is so long):

    I’d need to see correlations with + & – time-lags for me to feel like this was informing me about causes and effects. (I know, it’s a Very Big Chore to assemble that comprehensively.)
    From the get-go: the big problem with “M” aka money “supply” is that monetarists are not talking about a flow “supply,” but a stock.
    They’re vague and shifty about what stock: M1 (outstanding stock of physical currency)? M2 (private-nonbank checking/MM holdings/assets + M1)? MB (banks’ deposit/”reserve” holdings at the CB)?
    They say “supply” so they can imply some relationship in a supply & demand diagram, which simply makes no sense with stock measures.

    It’s all classic, fast-and-loose Romer mathiness:

    “mathiness uses a mixture of words and symbols, but instead of making tight links, it leaves ample room for slippage between statements in natural versus formal language.”

    MB bank assets are just a completely separate beast, functionally, and M2 assets only comprise 10-15% of total assets.
    The fact that people use M2 when they spend down (out of) their assets is purely mechanical. They’re xferring assets. Which is why I think velocity of wealth is so much more pertinent.
    Unfortunately the international data on wealthholdings, which only began to be available in the mid-2000s, is probably not sufficient to do this inflation (rate) vs wealth-change correlation analysis…

    Thanks for listening, as always. Cheers.

    • Hi Steve,

      Yes, I did the lag analysis, but then took it out for brevity purposes. It’ll probably be in a follow up post. Basically, the data shouts that rate hikes are a reaction to inflation. It makes sense in terms of a power struggle. Rate hikes are a way to redistribute income in their favor during an inflationary struggle.

      Agree about the ‘mathiness’ of monetarism. And if more expansive monetary came along, I’d be happy to use it. Seems the World Bank data that I used is actually compiled by the IMF. I’m not sure about the exact boundaries they used.

      • “data shouts that rate hikes are a reaction to inflation”

        That’s exactly what standard theory predicts: that Central Banks have a reaction function and will respond to higher inflation by increasing rates. Perhaps you just… did not know enough about the theory you are trying to take down?

        Furthermore, to make causal claims, you would need monetary shocks (exogenous unanticipated changes in monetary policy). Take a look at Romer and Romer 2004:

      • So higher interest rates are a reaction to inflation … indeed there’s no bound to how high they’ll go as long as inflation keeps up. And yet these high rates somehow down-regulate inflation. Yep … makes a lot of sense.

      • “Furthermore, to make causal claims, you would need monetary shocks ”

        That sounds awfully like I need to accept monetarism to make causal claims about inflation. No thanks.

  2. One dynamic to consider is the role of rate hikes on interest income paid by the government to the private sector. This is government spending, like any other gov spending, and is “money creation”. This applies to interest paid on bonds, interest on reserves, reverse repo, etc.

  3. Unlike your insulin and CO2 examples, your money supply and inflation examples do not have the time dimension which is necessary to make a causal claim. In reality, interest rates correlate with high inflation because interest rates are raised in response to high inflation.

    On a theoretical level, your argument fails due to belief in the erroneous Say’s Law. “if businesses practice cost-plus pricing (tacking a fixed markup onto existing costs), then higher interest rates should actually stoke inflation. Blasphemy, yes. But the idea is supported by the evidence.” You assume that everything produced can be sold at any price, which amounts to claiming prices are meaningless. In reality there is no guarantee that what is produced can be sold.

    See, the section that begins with “Nothing can be more childish than the dogma, that because every sale is a purchase, and every purchase a sale, therefore the circulation of commodities necessarily implies an equilibrium of sales and purchases.” until “This course constitutes its currency (cours de la monnaie).” including the footnotes.

    Incidentally, Keynes “rediscovered” that Say’s Law is false 50 years after Marx with the 1930 crisis in full view.

    Raising the interest rates do not cause prices to rise but output to fall, hence the tradeoff is between inflation and growth (which implies employment).

    • You’re putting words in my mouth. I never said that anything can be sold at any price. I proposed that many businesses have the power to raise prices when their costs increase. That power is not unlimited.

      Second, I was very clear that interest rates driving inflation is one of the possible interpretations that’s consistent with the evidence. The other is that lenders react to inflation rates by setting interest rates. I didn’t pass judgement on which one is true.

      • In the presence of competition, which enforces the law of value, businesses cannot arbitrarily tack a fixed markup (I assume this means a fixed % markup) onto costs to determine a new price when input costs go up. A fixed profit rate is not guaranteed to any business.

        Say a product at t1 has a value of $300 = $100 of V + $100 of C + $100 of S. That is a 50% markup.
        Now say C rises to $200 at t2. The value of the product is now $400 = $100 of V + $200 of C + $100 of S. We now have a 33% markup.

        The fixed markup assumption implies that the product will instead sell at $450, i.e. above its value. For this we must assume there aren’t competitors that can sell at value ($400). Furthermore they must have disappeared between t1 and t2. Is this the argument, i.e. that inflation creates monopolization? But the original argument was the opposite, that inflation is a result of monopolization (fixed cost-plus pricing).

        Note: You can pick a t1 sale price above value as well, say 10% above value, or $330 to account for a level of already existing monopolization. That gives you a 65% markup. With C rising to $200 at t2 and a fixed 65% markup, the price at t2 must become $495, which is now 23.75% above value rather than 10% above value like at t1. Hence again, you must assume pricing power (monopolization) increased specifically between t1 and t2.

  4. This is an impressive takedown of the orthodox assumption around interest rates and inflation.

    The next step is to seek empirical evidence for the theory that cost-plus pricing is ubiquitous and a mechanism that causes inflation. While it is plausible, it is also possible that there are other factors involved, especially since raising interest rates, according to Di Muzio’s charts, tends to follow inflation rather than precede it.

    Looking at your charts, the empirical question would be: to what extent do corporations have pricing power in the countries with a positive correlation, or lack it in the countries with a negative correlation? I.e. does the presence or absence of pricing power, particularly of commodities such as oil that are responsible for part of the cost of so many goods, explain the correlation differences? If not, what does?

  5. Here is an article by Lee and Werner that may be of interest (although not squarely on point). In it, they explore the effects of interest rates on GDP and finds the opposite of what the monetary orthodoxy predicts.

    “To investigate, we test the received belief that lower interest rates result in higher growth and higher rates result in lower growth. Examining the relationship between 3-month and 10-year benchmark rates and nominal GDP growth over half a century in four of the five largest economies we find that interest rates follow GDP growth and are consistently positively correlated with growth. If policy-makers really aimed at setting rates consistent with a recovery, they would need to raise them. We conclude that conventional monetary policy as operated by central banks for the past half-century is fundamentally flawed. Policy-makers had better focus on the quantity variables that cause growth.”

  6. To be clear, you are saying even if one looks at lagged effects – say change in rates vs change in observed inflation 12 or 18 months later for example – you don’t see the cause and effect relationship expected?

    Or is it that the monetarist grip on central banks is so complete that we never can observe the cases where an inflationary impulse was not met with rate hikes, so it’s impossible to distinguish the cause and effect?

    • Yes, in lagged data, it’s clear that interest hikes are a reaction to inflation. There’s no sign of the reverse effect — that interest hikes lead to a reduction of inflation.

  7. “Whenever inflation rears its head, the call soon comes to raise interest rates. The rationale is simple. Higher interest rates put a damper on the supply of money. And this monetary clamp slows inflation.”

    I’m afraid that’s not how it works. Where did you learn this?

  8. Couldn’t it be possible that higher rates indicate a rise in monetary tyranny (therefore leading to inflation)? In low-stability countries the lending rates are far higher, and low-stability countries happen to be ones where it is more likely a monetary tyrant will print vast supplies of money for themselves (causing inflation). I’d love to see data on “stable vs unstable” countries along with time-based measurement of “interest rate rises -> inflation rises”.

    • Yes, it would be interesting to differentiate between different countries. In this post, I’m mostly taking a general swing at monetarism. There’s lots of research yet to be done.

  9. Have you analyzed the difference between the red and blue countries?
    For example do the same countries show up red (or blue) in all three cases?

    Could it be a big country vs small country effect? Or maybe a wealthy country vs poor country?

    Or is it more random?

  10. Excellent article. I actually worked for Canada’s “Anti-Inflation Board”, as my first real job as a Juniour-G-Man Economist. It was summer of 1976, and inflation was running hot and very nasty in Canada. Quebec Nurses union had just got a 20% annual salary increase – and even the Marxist nut-jobs could recognize we all were in the deep poo. Interest rates were in the double-digits, as was unemployment rate. There were no jobs, and the economy was in basic free-fall (which was why I had moved to Ottawa for the summer, to take a “government job” at $780 per month wage.) The times were strange – like now. Our PM, Trudeau (Version 1.0), had blown out the budget, and had created a “Wage and Prices Control Program”, after running in an election where he promised he would do no such thing. It was – as I said – strange times, rather like now. (These Marxist clowns never can learn.)
    One thing I discovered, was that – mostly – higher interest rates were typically just passed forward as increased business costs, since most businesses were also up to their eyebrows in debt – and had to either die, or service that debt.
    It was bone-bangingly obvious. Raising interest rates caused inflation, because if most economic agents were in debt, the higher rates were just viewed – by both consumers and producers – as higher costs of operation, or higher costs of living.
    Really. God’s honest truth.

  11. I’m afraid that most orthodox economists won’t find much of anything in this. This is a particularly difficult area to research, so I think it’s important to put some things in perspective. The modern “orthodox” economist, is continually retreating from failed positions. Monetary supply targeting failed tremendously, randall wray has great videos on this, so now they

    This article “Historical approaches to monetary policy” has some great background information:

    “To deter runs on their gold reserves and preserve the gold standard, central banks at times sought to attract gold by raising interest rates”

    What this in essence is, is a ponzi scheme. Promising real returns is used to try to cover a liquidity problem, which only creates a worse solvency problem. But modern unpegged currencies are flexible, which is why I prefer instead to understand currency price action in terms of debt valuation. If the national debt is like a market cap, then the market value of the national debt is just what the currency is valued at by markets. If the debt is too big, you get inflation.

    Most people consider the currency separately, but without counting debt valuations, the currency is just

    Interest payments create allocate income to non-workers, more so than workers, so one would expect interest expense to not induce real output.

    Finally, the most important way I try to consider interest rate logic, is as an exchange rate between a currency and itself across time. The higher the interest rate, the cheaper it is to buy future money. If the interest is 10% then $1 today, buys $1.10 a year from now. If the interest rate is 100%, then $1 today buys a whopping $2 a year from now.

    Higher rate = Cheaper future money.

    Interest hikes, both at a micro and macro level are form of financial brinksmanship. When you charge more interest, to outstanding debtors, you force them to the table. They can walk away and then you lose it all anyway.

    On a macro level, it is not so different. A higher interest rate cannot be deflationary unless you force defaults, and defaults inherently mean you have compromised the integrity of what money is. Would it be deflationary if you raised rates so high that you “forced” a country to default on their own national debt? It’s not like that would actually increase real wealth or solve the underlying problem.

    The duration shock, a decline in the value of a future dated security based on interest rate change, is in fact a inflation effect. When you buy a tsy bond maturing in 2030, you have essentially bought a fixed amount of 2030 dollars. If the present value of that security declines, it does so because you have defined a path of prices with greater inflation between now and 2030.

    The way I like to describe the logic of the fisher equation is this: the nominal interest rate sets a benchmark for real returns, if you exceed that benchmark, you get deflation.

    I am not opposed to using some degree of nominal rate increase to signal tighter monetary policy, to spread inflation out over time, or to potentially decrease inflation volatility. However it should be done very judiciously. If an interest rate sounds like a ponzi scheme it probably is a ponzi scheme.

    But if rate hikes “work” to reduce inflation, all you have managed to do is to borrow more in real terms, under a higher nominal rate. Every form of borrowing money feels good when you first do it, and it’s not until years later that you really know if that paid off, if the present value was more than the cost. So even an 18 month lag is not enough.

    I call the time it takes for a difference in rates to double the value of one asset over another a monetary “half life”. A 1% rate difference has a half life of 70 years. Even a 10% rate difference has a half life of 7 years, and a lot can happen. The thing is, with one winning 50/50, double or nothing bet you can make it appear like an asset achieved 10% returns for 7 years.

    That’s why I think monetary “half-lives” are important, because before that, it is easy to mask gambling as a legitimate return. Been trying to get into this all on my blog(, but my writing can be hit or miss.

  12. 《I have been unable to construct an equilibrium model in which changes in money cause changes in prices or income, but I have had no trouble constructing an equilibrium model in which changes in prices or income cause changes in money.》

    Fischer Black, “Noise”

  13. […] recently on inflation is Blair Fix. He recently posted a great piece showing the empirical evidence to support the theory that higher interest rates increase inflation. His most recent piece reframes the whole question of inflation into the idea of competing price […]

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