A few weeks ago, Fed chairwoman Janet Yellen did not find it opportune to raise interest rates. She argued that oil prices are not contributing to a durable price rise toward the 2% inflation rate targeted by the Fed. The ECB (European Central Bank) does not show any intention to raise its interest rates either. The inflation-growth dynamics is simply not there yet. But, more than opportunity and intention, will the Fed and the ECB ever find an opportunity to significantly raise interest rates again?
Price inflation and economic growth
The idea that inflation is somehow linked to economic growth can be traced back to 16th century Mercantilism. The mercantilists defended accumulation of money balances in a country and low interest rates to stimulate industry with cheap capital. The idea eventually evolved into the “needs of trade” argument: as long as money is continuously made available to finance demand, production can go on without gluts. The idea was condemned by Adam Smith, David Ricardo, and Jean-Baptiste Say in the 18th and 19th centuries, and by Ludwig von Mises in the 20th century, to no avail as it persisted to this day. Indeed, central bankers estimate they can fine-tune the economy through a mixture of active monetary policy and announcement effects. In this manner, one can obtain controlled inflation giving leeway for production to keep growing. If price inflation is present, then, it would mean demand is relatively strong, leading producers into employing more workers and ordering more inventories, thus sustaining a virtuous cycle. This explains in a simple manner why policy-makers consider inflationary “sources” such as oil prices, imports, and wages to be so important.