Higher Key Rates, Higher Inflation? An Analysis of the Controversy Around Fiscal Theory of the Price Level

The conventional wisdom holds that higher interest rates combat inflation. But what if the opposite is true?

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<div class="sf-perspective"> <h3>SwissForecast Perspective</h3> <p>The question "Do higher key rates lead to higher inflation?" is directly relevant for construction suppliers: if the answer is yes, construction demand falls (higher financing costs) while material prices rise (inflation). A toxic scenario for the industry.</p> </div> <ul> <li>Conventional vs. Fiscal Theory: Conventional monetary theory holds that higher interest rates reduce inflation by dampening demand. The Fiscal Theory of the Price Level (FTPL) challenges this view, arguing that higher rates can actually increase inflation through increased government interest payments.</li> <li>Mechanism: According to FTPL, when governments have high debt levels, raising interest rates increases debt service costs. If these are financed through money creation or if markets expect future inflation, this can be inflationary rather than disinflationary.</li> </ul> <div class="sf-note"> <p>From the perspective of long-term debt cycles: at the end of a debt cycle, central banks print money to monetize government debt. This structurally drives up real assets (commodities, real estate) — regardless of the key rate. "Cash is trash" in late cycles.</p> </div> <ul> <li>Empirical Evidence: Recent experience in many advanced economies shows that despite aggressive interest rate hikes, inflation has remained persistent. This has renewed interest in FTPL as a potential explanation.</li> </ul> <div class="sf-data"> <p><strong>10% inflation (2022)</strong></p> <p>The Ukraine energy shock drove German inflation to its highest level since the 1970s. A historical reference point: what was called "transitory" took 18 months to normalize.</p> </div> <ul> <li>Policy Implications: If FTPL holds, central banks face a dilemma. Traditional monetary policy tools may be less effective or even counterproductive when government debt is high. Fiscal consolidation becomes essential for inflation control.</li> </ul> <div class="sf-note"> <p>From the perspective of perma-crisis analysis: stagflation — rising prices amid stagnating economy — is the most likely scenario when multiple crises reinforce each other. For the construction industry: falling demand with rising costs.</p> </div> <p>Central banks worldwide have raised interest rates aggressively to combat inflation. The conventional wisdom is clear: higher rates reduce demand, cool the economy, and bring down inflation. But what if this conventional wisdom is wrong? What if, under certain conditions, higher interest rates actually increase inflation? This is the provocative claim of the Fiscal Theory of the Price Level (FTPL), a heterodox economic theory that has gained renewed attention in recent years. This article examines the FTPL, analyzes its theoretical foundations, reviews the empirical evidence, and explores its implications for monetary and fiscal policy.</p> <h2>Conventional Monetary Theory</h2> <p>According to conventional monetary theory, central banks control inflation through interest rate policy. When inflation is too high, central banks raise interest rates. This makes borrowing more expensive, reduces consumption and investment, dampens aggregate demand, and ultimately brings down inflation. This is the standard textbook view taught in economics courses and followed by central banks worldwide.</p> <h2>The Fiscal Theory Alternative</h2> <p>The Fiscal Theory of the Price Level offers a radically different perspective. According to FTPL, the price level is ultimately determined not by monetary policy but by fiscal policy – specifically, by the government's intertemporal budget constraint. In simple terms, the price level adjusts to ensure that the real value of government debt equals the present value of expected future primary surpluses.</p> <p>The key insight is that when government debt is high and interest rates rise, debt service costs increase. If the government finances these higher costs through money creation, or if markets expect future inflation to erode the real value of debt, this can be inflationary. In this view, raising interest rates can paradoxically increase rather than decrease inflation.</p> <h2>Empirical Evidence and Recent Experience</h2> <p>Recent experience in many advanced economies provides some support for FTPL. Despite aggressive interest rate hikes by central banks in 2022-2024, inflation has proven persistent. While conventional factors like supply chain disruptions and energy prices played a role, the persistence of inflation despite tight monetary policy has puzzled many economists.</p> <p>Some researchers point to the fact that government debt levels in many countries are historically high, and rising interest rates have significantly increased debt service costs. In the USA, for example, interest payments on federal debt have surged, requiring increased government borrowing. This is consistent with the FTPL mechanism.</p> <h2>Case Study Japan: The Deflationary Laboratory</h2> <p>Japan's economy has provided a perfect case study for over three decades that challenges conventional theory and supports the FTPL.</p> <h3>Why Did Monetary Policy Fail in Japan?</h3> <h3>Structural Factors</h3> <p>The literature agrees on a number of structural problems that caused or entrenched deflation: a broken banking system after the bubble burst (non-performing loans), an aging and shrinking population, a "balance sheet recession" in which companies focused on deleveraging rather than investment, and high risk aversion among banks. The transmission mechanism of monetary policy was broken.</p> <ul> <li>Fiscal Interpretation: Despite Japan's massive public debt (&gt;250% of GDP), there was no sudden, perceived-as-uncovered fiscal shock as in the USA in 2021. Debt grew gradually, and fiscal measures such as consumption tax increases were actually deflationary. Without a fiscal impulse, inflation failed to materialize regardless of how loose monetary policy was.</li> <li>Neo-Fisherian Interpretation: Decades of zero interest rate policy cemented deflationary expectations. A policy that permanently signals low rates also signals permanently low inflation. The Bank of Japan's failed attempt to raise rates modestly in 2000 led to a worsening of deflation — an outcome difficult to reconcile with conventional theory but consistent with Neo-Fisherian logic [7].</li> </ul> <h2>Policy Implications and Conclusion</h2> <p>If FTPL holds, the implications for policy are profound. Central banks cannot control inflation through interest rate policy alone when government debt is high. Fiscal consolidation – reducing deficits and debt levels – becomes essential for inflation control. This creates a difficult political challenge, as fiscal consolidation is often unpopular and economically painful.</p> <p>The question of whether higher key rates lead to higher or lower inflation cannot be answered categorically. The analysis, inspired by the work of John H. Cochrane, suggests that the answer depends on two decisive factors:</p> <ol> <li><strong>The persistence of the rate change:</strong> A rate hike perceived as temporary can work conventionally by dampening demand. A rate change seen as permanent forces an adjustment of inflation expectations in line with Neo-Fisherianism.</li> <li><strong>The fiscal policy response:</strong> This is the decisive factor. A rate hike can only sustainably dampen inflation if the government offsets the resulting higher debt service costs through credible fiscal consolidation (tax increases or spending cuts). If this fiscal support is absent, the rate hike risks actually increasing inflation through the fiscal channel.</li> </ol> <p>The experiences of recent years and the case of Japan are strong indications that an inflation analysis focused purely on monetary policy falls short. The extremely low rates after 2008 did not produce the feared inflation because an expansionary fiscal shock was absent. The inflation after 2021 was not primarily caused by low rates but by massive, uncovered government spending. Japan shows that monetary policy reaches its limits when structural problems and absent fiscal expansion coincide.</p> <p>In summary, the question touches the core of a fundamental debate in macroeconomics. The view championed by John H. Cochrane — that fiscal policy is the ultimate anchor for the price level — offers a coherent explanation for many phenomena that are difficult to explain in the standard model. A rate hike is not a magic switch for fighting inflation; its effectiveness is inextricably linked to the soundness and credibility of public finances.</p> <p>The debate between conventional monetary theory and FTPL is far from settled. Both perspectives offer valuable insights, and the truth likely lies somewhere in between. What is clear is that in an era of high government debt, the interaction between monetary and fiscal policy is more complex than traditional models suggest. Policymakers must consider both monetary and fiscal factors when addressing inflation.</p> <h2>References</h2> <p>[1] Cochrane, J. H. (2016). <em>Do Higher Interest Rates Raise or Lower Inflation?</em> University of Chicago, Becker Friedman Institute. Available: <a href="https://bfi.uchicago.edu/wp-content/uploads/fisher.pdf">https://bfi.uchicago.edu/wp-content/uploads/fisher.pdf</a></p> <p>[2] Cochrane, J. H. (2023, April 20). <em>How do interest rates lower inflation?</em> The Grumpy Economist. Available: <a href="https://johnhcochrane.blogspot.com/2023/04/how-do-interest-rates-lower-inflation.html">https://johnhcochrane.blogspot.com/2023/04/how-do-interest-rates-lower-inflation.html</a></p> <p>[3] Uribe, M. (2022). The Neo-Fisher Effect: Econometric Evidence from Empirical and Optimizing Models. <em>American Economic Journal: Macroeconomics</em>, 14(4), 1–41. Available: <a href="https://www.nber.org/papers/w25089">https://www.nber.org/papers/w25089</a></p> <p>[4] Cochrane, J. H. (2023). <em>The Fiscal Theory of the Price Level.</em> Princeton University Press. Available: <a href="https://www.johnhcochrane.com/research-all/the-fiscal-theory-of-the-price-level-1">https://www.johnhcochrane.com/research-all/the-fiscal-theory-of-the-price-level-1</a></p> <p>[5] Cochrane, J. H. (2024, January 29). <em>Fiscal Narratives for US Inflation.</em> Available: <a href="https://www.johnhcochrane.com/s/Sims_comment.pdf">https://www.johnhcochrane.com/s/Sims_comment.pdf</a></p> <p>[6] Nishizaki, K., Sekine, T., Ueno, Y., &amp; Kawai, Y. (2012). <em>Chronic deflation in Japan.</em> BIS Papers No 70. Available: <a href="https://www.bis.org/publ/bppdf/bispap70c.pdf">https://www.bis.org/publ/bppdf/bispap70c.pdf</a></p> <p>[7] Ito, T., &amp; Mishkin, F. S. (2006). Two Decades of Japanese Monetary Policy and the Deflation Problem. In <em>Monetary Policy with Very Low Inflation in the Pacific Rim.</em> University of Chicago Press. Available: <a href="https://www.nber.org/papers/w10833">https://www.nber.org/papers/w10833</a></p> <div class="sf-perspective"> <h3>Procurement Takeaway</h3> <p>For material price forecasts: the key rate-inflation relationship is not linear. In a stagflation scenario, material prices rise even with weak demand — because the supply side (energy, transport, regulation) drives costs, not demand.</p> </div>

Published

2025-01-15