Economics Professor Explains Link Between Interest Rates, Inflation

(KNSI) – The Federal Reserve has hiked interest rates by another three-quarter of a percent with another expected in December.

College of St. Benedict and Saint John’s University Economics Professor Louis Johnston explains how financial tightening brings down inflation.

“We’ve been living with what are known as negative real interest rates, meaning banks, in a sense, are paying borrowers to borrow money. And now interest rates have finally increased enough so that we have positive real interest rates. That is the amount of money that people are borrowing they’re having to pay back in more valuable dollars.”

The Fed Funds rate, now four percent, determines how much banks can earn by keeping their reserves held at the various branches of the central bank. In order to lend those reserves out, the project must generate a high return with a low risk of failure. Many borrowers are shut out, forcing them to rely on cash on hand and limiting speculation.

Federal Reserve Chairman Jerome Powell is trying to figure out how long it will take before the rate hikes have an effect. Johnston says there are several factors when trying to determine the delay.

“Milton Friedman said monetary policy works with a long and variable lag. It depends on the state of the economy. It also depends on companies’ borrowing needs. So for example, if you’re in a situation where companies are not needing to borrow very much, they’re financing their investment out of retained earnings, then it’s going to be a while.”

Companies borrowed heavily when rates were at record lows in 2020 and 2021. Businesses saw record corporate profits leading up to the Fed’s change in policy. Many are well-positioned to avoid new debt in the near term. Johnston thinks the lag this time will be between six and nine months. Inflation may remain elevated until then.

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