Higher Interest Rates Might Drive Inflation, And We Need To Decide Very Quickly If That Is True

A surprising number of economists have recently said that they believe high rates drive inflation. This is scary for two reasons. The first reason is that the people in charge may be wrong about one of our fundamental principles; higher interest rates are used to fight inflation. This is a central tenet of economic policy as it stands today and suddenly being uncertain means that too much time was spent teaching the macarena in school. The second problem is that countries are raising rates rapidly to fight inflation. If they are wrong and increase the problem, it would have severe consequences.

The arguments for high rates further driving inflation are surprisingly rational and outlined below. It’s also important to understand that even if this proves to be true it doesn’t mean it needs to be the main cause of inflation. Inflation can still be caused by several additional items, such as a supply shock, and accommodative fiscal policy.

When rates are raised, we immediately see the impacts, as bonds fall. Bonds are the largest liquid asset class in the world and a retreat in their value signals that excess is leaving the system. The argument against this is that a price drop is simply a function of mark-to-market mechanics. Picture a pension fund with a large allocation to bonds. The amount they pay to pensioners is very likely already set and the change in the value of the bonds isn’t real dollars and doesn’t impact this amount. These bonds will still pay out the exact amount they were originally expected to receive. I understand there are several nuances in this simplified statement around the duration of assets and liabilities for market participants, but there are word limits (I’m going to start saying this any time I don’t want to address something further).

Contrast the above with the higher cash flows that are received by all holders of newly issued bonds as rates rise. If you are a retiree that is holding bonds you do not care about their mark-to-market value. You bought them for their certainty, and you receive the same amount of cash that you expected. When the bond matures you likely already planned to reinvest these cash flows. Except now when you reinvest you will get a higher ongoing stream of cash from these new interest payments. These excess cash flows can very likely be spent, driving inflation.

Another validator is that low rates were deflationary in several ways. It is reasonable to assume the opposite is also true. We saw this play out in real-time as cheap capital helped drive energy oversupply this past decade. Energy has been shown to return its cost of capital in the long run. This is largely true of any commodity business in the aggregate, even though there are still exceptional operators within the sector. Cheap capital lowers the cost of energy, and energy is an input in everything.

Technology is another deflationary force, but also the industry most susceptible to rates, given the cash flows are typically farther in the future than legacy industries. When rates are low it is most supportive of technology names. Higher rates slow this engine.

Finally, interest payments represent one of the biggest obligations for a government. Their main inflows are taxes. Central banks have increased their rates sevenfold. There are several nuances on how this doesn’t translate to increased costs immediately, as it takes multiple years to work into funding costs, but the key takeaway is that there is zero chance taxes can keep up. This means more money has to be printed to plug the gap, which we know to be inflationary. Watch the debt ceiling debate play out in the US over the next several years as evidence of this.

All of these are surprisingly compelling arguments that higher rates could drive inflation. This would mean that inflation may remain high. The scary thing about the feedback loop is the people in charge of rates are programmed to raise them in response to inflation, which would be the opposite of what is required. This is all worth thinking about seriously given the consequences.