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Friday, November 15, 2013

Lowering Interest Rates is Deflationary by Definition

When Ford Motor lowers the price of a car, that is a deflationary act by definition.  The possibility that the lower price may lead to the sale of more cars does not alter that fact.  The fact that consumers may have some extra money in their pocket after purchasing their car, and use that to buy something else, does not alter the basic fact that lower prices are the realization of deflation.

When the Federal Reserve lowers the price of borrowing, that is a deflationary act by definition.  The fact that the lower price may lead to more loans does not alter that fact.  The fact that borrowers may have some extra money in their pocket after making payments on loans does not alter the fact that the lowered price for borrowing represents deflation in and of itself.

Compounding this obvious first order deflation, the lowered interest rates lower the fiscal balance and thus result in a smaller injection of money from the government into the economy.

There are undoubtedly other effects of lowering interest rates, but these are not so cut and dried as commonly assumed.  Any private loan has two private parties.  Lowering the price for the borrower lowers revenue for the lender, with no net change in income.

An in-depth analysis of the various effects of interest rate changes on the economy will reveal a number of additional considerations.   The argument that is generally made by proponents of monetary policy is that lower rates will lead to increased investment, since the lower price of bank loans will make them more attractive.  But, as we see via Phil Pilkington,
[Keynes'] account of a boom is to say that a high rate of investment causes a fall in expected profits as the supply of productive capacity increases… one thing he would have never have said is that a permanently lower level of the rate of interest would create a permanently higher rate of investment.
This ties into Kalecki’s argument that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone. He presents the following graph which shows precisely this dynamic...
Randall Wray provides additional detailed analysis:
Some years ago I co-authored a paper with my colleague Linwood Tauheed, titled SYSTEM DYNAMICS OF INTEREST RATE EFFECTS ON AGGREGATE DEMAND, that investigated the likely impacts of interest rate changes on aggregate demand. We used conventional estimates of interest rate elasticities for investment spending, as well as for parameters like the marginal propensity to consume...  In particular, pay attention to the discussion of conventional estimates of interest rate elasticities—which are surprisingly small
If the price of lumber goes down by a small amount, this doesn't automatically mean that the demand for houses will surge.  Similarly, if the price of borrowing money goes down by a small amount, this doesn't automatically mean that the demand to build new factories will surge.  The cost of borrowing is just one factor among many.  Deflation in borrowing costs is deflationary in and of itself.  The second and higher order effects are subject to debate, but the empirical data from recent U.S. history shows lower interest rates highly correlated with decreasing inflation (and vice versa).  As evidence in support of this assertion, here's my favorite graph:

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