A novel theory about the economy suggests rates need to come down to beat inflation

Central banks have a simple formula for fighting inflation: raise interest rates, wait for the economy to weaken and demand to fall, and inflation will soon follow suit. 

What if the formula is wrong?

Catch up: Some experts are making the case that higher interest rates are now driving stubborn inflation that’s sticking around both in the U.S. and Canada.

  • “A lot of what's going with inflation today can be linked very closely to interest rates,” JPMorgan market strategist Jack Manley told Bloomberg. “It’s shelter, it’s automobile insurance — both of these things are direct reflections of the interest rate environment.”

In Canada: The rising price of shelter — mortgage interest and rents — now accounts for more than half of inflation. Interest rate hikes are partially responsible for the rise of both of those components.

  • Higher rates make mortgages more expensive and tend to depress new home construction, worsening a supply shortage that’s driving up rents and prices.

  • As a consequence, TD economists have suggested the Bank of Canada start excluding shelter costs from its decision making, a change that would almost certainly result in earlier rate cuts.

Why it matters: Interest rates are central banks’ go-to method for managing inflation. If they can’t rely on higher rates to keep inflation in check, governments will need to start looking for other tools to do the job.

Yes, but: Inflation has come down as interest rates have gone up, which is consistent with what mainstream economic theory predicts — though without the high levels of unemployment or sharp recession many economists believed would be necessary. 

  • One of those economists, Larry Summers, says swift rate hikes persuaded people central banks would do whatever it took to keep inflation low, and that the role of inflation expectations may be more important than previously thought.

Bottom line: Our post-pandemic experience is forcing a rethink of how to deal with inflation, but until we have a better theory policymakers will continue using the tool — interest rates — they have at hand.—TS