Monetary Policy Has No Influence On Price Inflation

by: Ivan Kitov

The interest rate defined by the Federal Reserve is claimed to be an instrument to control inflation. The shamanism around the interest rate is often called monetary policy. Ignoring the heaps of worthless economic models and weird (e.g. counter-scientific) explanation of the FOMC members of the effects of monetary policy, we present some simple observations.

Figure 1 depicts the effective interest rate, R, and the rate of consumer price inflation, CPI. The former has to control/affect the latter. One can see that the funds rate lags behind the CPI since 1980, i.e. inflation grows at its own rate and R has to follow up. The idea of R is that a higher rate should suppress inflation due to the effect expensive money. The reaction of inflation is also expected to be not simultaneous but with some time lag. When R>CPI or R<CPI for a long time, CPI should go down or up, respectively. Thus, one expects that the cumulative influence of the interest rate should produce a desired effect in the long run and inflation should go in the direction towards bearable values.

Figure 2 displays the cumulative effect, i.e. the cumulative values of the monthly estimates of R and CPI multiplied by 1.4. This is an intriguing plot. In the long run, the R curve fluctuates around the CPI one and returns to it every 15 to 20 years. Apparently, the sign of deviation of R from the 1.4CPI curve does not affect the behavior of the CPI. Therefore, the influence of monetary policy is under strong doubt. The Feds have tried all means to return the CPI to R without any success and have to return R to the CPI whatever is the inherent movement in price inflation.

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Figure 1. The federal funds rate, R, and the rate of consumer price inflation, CPI, between 1956 and 2012.

Figure 2. Cumulative values of the monthly estimates of R and CPI multiplied by a factor of 1.4.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.