How does a change in interest rates affect inflation. We are talking about some absolutely basic economical knowledge here. Raising interest rates cools the economy as businesses invest less and develop slower due to more expensive credit. Lowering rates works the other way. The whole economy gets a boost thanks to cheaper credit, that is available from commercial banks.
Should we see a negative correlation between the two variables? Not exactly. The interest rates are also supposed to compensate for the higher inflation. The inflation rate is taken into account by central banks, when they set their official interest rates. As a result, the variables are always correlated positively. The chart no 1 presents a beautiful 78% correlation of the variables. Higher inflation - higher interest rates, it's as simple as that.
Some real data about EUR/USD moving averages
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| Chart 1. US Federal Funds Rate vs US Inflation (annual data) |
If the variables are correlated positively, how can we see Keynesian economics at work? The answer is - we should look at the rate of change. There is no doubt here. A movement up in interest rate should result in a lowered inflation. This is how economies work.
A surprising relation between US GDP and the dollar index
![US Fed Rate Change / US inflation change [Annual data, change from a year ago]](https://blogger.googleusercontent.com/img/a/AVvXsEglkEzU5PEbgjcjs2cDYZ833aIQUsMfWOUunlbxdJdlqpNseAD8sMovmSVX6DSVJUhrqiKZxHa3AycaYJRqGwDoyrqDgdGBJsVWvtcjtxqu-cjbQLRffTZbtAL1FZ63ntvDHl2n7uknrpAhZsXoa1pnaC1spgNbymcrtsf_GlrGWspyTnHfdqV1r486=w640-h558 "US Fed Rate Change / US inflation change [Annual data, change from a year ago]") |
US Fed Rate Change / US inflation change [Annual data, change from a year ago] |
Are you surprised to see another beautiful positive correlation? This time it is just 58%. Still a very solid number. Both variables clearly go hand in hand. Lowering rates does not stimulate the economy. At least not in the United States between 1960 and 2020.
As a matter of fact I would like to see any piece of Keynesian theory really doing its job as intended, in the long run.
Data credits
Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, October 7, 2021.
World Bank, Inflation, consumer prices for the United States [FPCPITOTLZGUSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FPCPITOTLZGUSA, October 7, 2021.