There’s a misunderstanding about the interest rate monetary policy tool and it’s very simple. with high inflation rates and a decrease in money purchasing power, the Central Banks have to increase the level of interest rate on money above the rate of inflation, to bring back to balance the real money supply. Real money supply, requires that money has a stable purchasing power, that’s not printing money, that also supports the currency against exogenous price and costs volatility, in fact, a prolonged devaluation of a currency often becomes a precursor of a financial crisis. The basic concept, it’s that by increasing the cost of borrowing, Central Banks apply the breaks on private credit creation made by the banking system, making credit more expensive. That brings decreases in the money supply.
Then banks have to adjust their underwriting standards to provide credit with higher interest rates because banks borrow in money markets, with short terms rates and provide credit to their clients with a longer timeframe duration of course with a markup on interest rates that’s the banks’ profitability with net interest rates margins. For that to have a real money supply, discounted for the current rate of inflation, then the Central Bank and private banks are required to increase interest rates on credit and on deposits.
Surprisingly, it’s through a higher rate of savings per worker that productivity also can increase because higher rates of savings are conducive to investments in the economy and with that, the output equilibria of the economy shift to a higher point ( see Solow Growth Model).
When the Central Bank increases the interest rate carried on money markets, that should achieve a few objectives: 1)Making the cost of borrowing more expensive to decrease the money supply created by banks. 2) Increase the rates and the stock of cash savings in the economy in aggregate, 3) balance the real money supply in the credit markets and in the economy, by factoring in the current rate of inflation, to produce equilibria between assets returns and real money, 4) Increase the velocity of money that it’s the ratio between aggregate national GDP in currency unit terms and the money supply(denominator)when the money supply (denominator) in the ratio decreases the factor output of Money Velocity expands. 5) Central Banks must increase money markets interest rates to preserve Price Stability and with that to prevent a spiralling devaluation and loss of confidence in a currency because that outcome produces a much worse financial crisis.
Then what are the exogenous variables with INFLATION? In simple terms, there are two factors: 1)Demand Driven Sugar High Inflation, which dampens when consumers are maxed out. 2) SUPPLY CONSTRAINT DRIVEN INFLATION, which has some peculiar characteristics; the main factor it’s that SUPPLY CONSTRAINT INFLATION has long-lasting effects on the economy and arguably could be “difficult” to anticipate when masked by a surge in Demand.
Indeed, advanced economies with fully functioning money markets and capital markets have skewed their economies in a peculiar situation. Very simple, when the aggregate quantity of money and near money instruments available in the economy expands, in the medium to long term that produces a shift to another equilibrium point in the economy that works through the clearing of prices and wages, the output and input costs of businesses. Once the money supply expands goods and services bake in a higher expensive price, the new prices, that requires higher levels of wages to work, because when businesses mark up their output of goods and services, they need consumers with purchasing power to buy their output, so wages are increased. After wages are increased there are collateral effects of rising unemployment in particular when businesses hit the buffer of price hikes and they can’t increase anymore the output price of goods and services. In simple terms, when the packaging of any item changes the price, that’s all, the CONSUMER AND THE INFLATION RATE ARE DONE; goods and services prices change equilibria point and clear to higher more expensive levels. That makes then clear that most of the GDP and Nominal GDP in advanced economies, in particular, in the past two decades, has been achieved by expanding the money supply.
That pass-through effect of INFLATING THE MONEY SUPPLY, first INFLATES ASSETS, THEN WHEN THE GOVERNMENTS MAKES FISCAL STIMULUS WITH DIRECT TRANSFER PAYMENTS THAT KICKS IN THE MUCH POTENT COLLATERAL EFFECT OF SPENDING. IT’S BASICALLY CHEAP CREDIT FOR TOO LONG TIME.
The collateral damage of interest rate hikes becomes the cost of credit. and the ASSETS PRICE INFLATION IN THE HOUSING MARKET HAS FORCED MILLIONS OF PEOPLE to BORROW INFLATED AMOUNTS OF CREDIT BASED ON HIGHLY INFLATED HOUSE PRICES, and often we hear that monetary policy transmission mechanisms function with lags. That’s to say that probably Central Banks staff are asked to model negative shocks to the economy, decrease in GDP, decreased in aggregate demand, and the effects of higher unemployment on GDP, so it can be argued that monetary policy thinking has been characterized by trying to keep the economy going and prevent negative shocks that would have dampened GDP growth because Central Banks and Governments don’t want to see the economy shrinking into recession.
In other words, consumers have to keep spending and Asset prices have to keep inflating. This has brought monetary policy not to model for excess volatility of prices and financial assets. There to say, they kept everything bubbling along, like your salt water past pot and sauce.
When it comes to lagging effects of monetary policy, probably Central Bank staff and boards have a bias in not VAR modelling impulses for high volatility in terms of INCREASING ASSETS PRICES and GOODS AND SERVICES PRICES. That’s why they have been so unprepared for volatility shocks of SUPPLY CONSTRAINT AND INPUT COSTS INCREASES ACROSS THE BOARD. WHILE MONETARISTS COMPLETELY DISREGARD THE HUGE ISSUE OF ASSET PRICE INFLATION AND DEBT FINANCE INFLATION.