Do interest rates lead inflation or does inflation lead interest rates?

I'm not Occrider, but i think i can lend a hand..

A short answer to your question is that they both effect eachother. Changing the interest rate has the effect of manipulating the amount of money in the economy and thus the amount of money people have in their pockets. High Interest rates = less money = less spending = lower inflation. If, however, inflation gets too low (as when housing markets go into a slump.. because of people's poor outlook on the economy) then the central bank has incentive to drop interest rates to stimulate spending again..

So yeah, we usually see an inverse relationship between the two (in Australia anyway).

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I thought inflation had more to do with pricing and that interest rates followed higher prices(at least in the environment that we are currently in) such that the risk free rate of return would be pushed up to to mitigate the impact of higher prices on the consumer. i.e John C. Pocketbook can earn more interest to pay for his ever rising energy and insurance bills. In such an environment, isn't current inflation forcing the Fed's hand to raise rates, particularly since they have been at such a low base for a decent stretch of time?

I guess a follow up question to that would be, is inflation(for whatever the cause) going to force Greenspan & co. to stick the needle in the housing bonanza and the massive credit bubble that has built up?

The Fed has raised rates now 8 times (granted in small increments), and according to ISI there has never been a situation where rates were raised 7 consecutive times where a recession didn't follow. Do we learn from history?

But back to the original question: Typically speaking, does inflation lead prevailing interest rates or is there a vice versa scenario?

Edit: I realize that I didn't even delve into the weak dollar at all. I'm just trying to keep it simple.

Last edited by Shakka on May-15-2005 at 20:00

I would say they both effect each other........

Government monetary policy aims to infleunce the overall level of monetary demand in the economy so that it grows broadly in line with the economys ability to produce goods and services. This stops output rising to quickly or slowly. Interest rates are increased to moderate demand and inflation, and they are reduced to stimulate demand. If interest rates are set to low, this may encourage the build up of inflationary pressure; If they are set to high, demand will be lower than necessary to control inflation.

Basically both short term and long term interest rates are affected by economic factors such as inflation, the strength of the US Dollar in your case, and the pace of economic growth. But by raising or lowering interest rates you can also effect and control inflation.

So to say that one leads the other ie last periods interest rate increase leads to this periods inflation rate or vice versa, i would say that that cant strictly be true because of many other factors in a given economy.

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Short answer: Inflationary expectations lead nominal interest rates (federal funds rate) while inflation (CPI and other inflationary indicators) and real interest rates (inflation - nominal interest rates) lead inflationary expectations.

Long answer:
According to Robert Mundell, the nominal rate of interest is set by inflation expectations and the real interest rate. Suppose we have two assets, money and equity. By Keynes's theory of liquidity preference, money demand is inversely related to the return on alternative assets. As money supply rises, the rate of interest falls. If we map out a money market graph we can determine the equilibrium by looking at the interest rate and the money supply. The money market curve is conditional to a particular level of inflationary expectations. If inflationary expectations rise then for any amount of money supply, the real interest rate falls and money market curve shifts down. The negative of inflation is the real rate of return on money. In the event that there are inflationary expectations, those who hold money are receiving a negative expected rate of return on their real balances and will get rid of them by purchasing equity.

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