Wednesday, February 16, 2011

Interest Rates And External Factors

So, FLG was listening to a podcast from the BBC this morning. They were discussing the rise in inflation over in the UK. The were debating whether this meant a raise in interest rates was on the way, and one commentator said that because the cause of the inflation was "external factors including rising prices for energy and commodities" that raising interest rates wouldn't do anything to tamp down inflation/

FLG thought to himself, that's a stupid comment. If you raise interest rates, then that makes investing in pounds more appealing to investors, they should then start buying pounds, which in turn would strengthen the pound. That's basic international finance.

If the pound strengthens vis-a-vis the dollar, which is what most commodities are priced in, and the law of one price holds, then the prices of commodities and energy will fall in pounds. Thus, you mitigate inflation.

Whether the BoE should raise rates given the currently weak state of the economy and the fiscal tightening going on, well, that's a completely different question. But raising interest rates should, if FLG's logic was solid, fight the inflation pressures, including the external ones.

1 comment:

LibertyAtStake said...

I'm no economics expert. But a big takeaway for me from a graduate macro-economics course I once took was "interest is the cost of money." So, since the basic nature of inflation is a precipitous decrease in money's value - I would say you got it exactly right.

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