The effects of current lower interest rates on Inflation
The US federal reserve has been reducing interest rates for the past 1 year and now it is close to a historic low at 1%. If all other factors are equal inflation grows inversely proportional to interest rates. Thus, a lot people believe easy money policies by itself will cause inflation no matter what
happens in the rest of the economy. It is not the case as seen in the graph to the left. Core inflation (ignoring food and energy – green graph) reduced in the last three years while overall inflation is reducing in the past few months (blue curve).
Let’s analyze the effect of money supply on inflation:
According to monetary theory
price level = Money supply * Velocity/Total product Output
where, GDP = Money supply * Velocity
Money supply is indirectly proportional to Interest rate, so price level is directly affected by interest rates. However, in case of recessions, Velocity can drop significantly, while output drops relatively smaller and thus prices go lower. Thus, in recessions/depression money supply has to be increased to make up for the velocity drop to keep price levels constant and not allow GDP from dropping.
Velocity in economics mean how fast people spend an unit of money they have got, and measured in terms of how many times the same dollar is used to get an unit of product. In boom times, people spend very fast and velocity is pretty high and during depression, people hold it very tight and velocity drops.
Now, what about Japan that was trying to inflate its way out of recession last decade but still couldn’t spur up economic growth or inflation? Japan has a very low velocity compared to most countries including US. The drop in velocity keeps eating away the gains from increase in money supply. And money supply itself is affected by other factors apart from interest rates:
a) Currency drain: Money multiplier = 1/currency with people(ignoring reserves in the equation). Basically, as more people hold on their money as currency instead of putting in the bank and supplying to rest of the economy, money multiplier reduces thereby reducing money supply. In depressions when people lose trust in banking system and keep it in mattresses, this happens.
b) Bank reserves: Money supply in an economy is greatly multiplied by the fractional reserve banking where each dollar from the Fed is typically multiplied by 1/reserve ratio. So, if the reserve ratio is increased, money supply is substantially reduced. Normally reserve ratios are only controlled by the Fed. In the current case, the banks are so paranoid that they are keeping more reserves than legal limits, thereby increasing the reserve ratio. If the reserve ratio increases from say 3% to 5%, money supply can contract by 30%.
BLS publishes the CPI which actually states what a dollar in one period can buy in another period. Inflation rate is just a derivative from this statistic. So, here is the combine CPI since 1913, using 1982 dollars. $1 in 1982 could buy $2 worth in 2008 and a dollar in 1913 could buy you 23 dollars now.
Here is the deflation during great depression. Basically an average item that cost 17 bucks in 1929 costs only 13 bucks in 1913 or almost 25% down. Many people fear a similar thing.
Thus, even if Federal Reserve reduces interest rates drastically the money supply might not increase a lot, and the smaller increase in money supply might get compensated by the decreasing velocity.
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Image reference: http://online.wsj.com/article/SB122419852898842701.html
