Intro: Lower interest rates tend to create upward pressure on inflation as they encourage greater bank lending, increase the incentive to spend money rather than hoard it, and discourage people from holding the currency as an investment. That said, given the multitude of forces at play, rate cuts are far from guaranteed to generate high inflation pressures.
The first thing to keep in mind when assessing the impact of an interest rate change on inflation is that real interest rates are what ultimately matter for real economic outcomes. If inflation itself is falling then real interest rates may actually rise even amid nominal interest rate cuts, something which we saw in many developed economies during the global financial crisis. Conversely, rising inflation in the absence of rate hikes can become self-reinforcing as real interest rates tend to decline further.
For the most part though, interest rate cuts tend to result in lower real interest rates, and economists tend to favour interest rate cuts as they ‘spur demand’. This vague wording, however, avoids getting to the heart of the actual processes at play. For example, economists often point to the fact that declining mortgage borrowing costs will put more money in the hands of consumers which will increase spending and therefore inflation. However, what about the person who is receiving the interest on the mortgage in one form or another? All debt interest paid is debt interest received so any increase in spending ability on the part of the homeowner will come at the expense of the creditor.
As with most things in economics, it is helpful to look at the aggregate picture in terms of simply supply and demand, in this case the supply of and the demand for money. Rate cuts tend to have an inflationary effect, all else equal, because they increase the supply of money and reduce the demand for money relative to goods and services and other assets.
Increased Money Supply: Interest rate cuts encourage people to take on new loans as affordability increases, and in doing so this increases the money supply. By increasing the money supply, total spending increases, while goods and services growth is unlikely to rise for reasons explained here. As a result, the net impact is higher prices.
Reduced Money Demand: Rate cuts encourage consumers and businesses to bring forward purchases of goods and services as the opportunity cost of holding onto cash increases. It also discourages investors from holding the currency as an investment, which results in currency depreciation and higher import costs.
However, this does not mean that interest rate cuts must result in higher inflation as they can easily be offset or even outweighed by other factors. In fact, due to the multitude of forces at play, it is very difficult to find evidence that shows interest rate changes lead to changes in inflation. However, if an economy experiencing declining inflation undergoes an interest rate cut and inflation falls further, it is fair to say that in the absence of the interest rate cut inflation would likely have fallen further still.
