Thursday, May 20, 2010

Cause and Effect

Jerry continues:
If the interest rates were the CAUSE and the inflation the EFFECT, I would think that the inflation would lag a bit behind the rate changes, right? Looking at it, I think the opposite is happening - the blue line peaks or bottoms out first.

Oh yes, existing policy fights inflation by raising interest rates. So we should expect to see inflation lead and interest rates lag, if and when they show a similar pattern. But for the early post-war years they don't show a similar pattern at all. Then again in the later post-war years, the similarity is obvious! Clearly, there was a change somewhere along the way.

The increasing reliance on credit was the cause of that change. And the similarity of interest rates and inflation, regardless of lead/lag, is one result of the change.

Note that if the Federal Reserve anticipates inflation and responds proactively to prevent it, interest rates may lead and inflation lag. Just the opposite of your supposition.

It strikes me that an alternative explanation for that second chart could be the "Taylor rule". Part of the "rule" was that your interest rates should go up if inflation is going up. So if the Fed were using that rule to set interest rates, you would expect that the purple line would follow the blue, since they are watching the blue line and basically trying to match it. It wouldn't be exactly right, since there are other terms in the rule (GDP growth). But there would be some correlation.

Jerry, you are the only person I know who could take that formula and work backwards to understand what it says about economic policy.

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