How does inflation affect the economy when interest rates are near zero?

When central banks are keeping policy interest rates near to zero, inflation has a big impact on the economy, notably by making real interest rates negative. This redistributes from savers to borrowers – and since the government is the largest borrower, there is a substantial ‘inflation tax’.

Inflation is rising to levels that are much higher than we have experienced in the last three decades. Since the global financial crisis of 2007-09, the Monetary Policy Committee (MPC) of the Bank of England has kept interest rates at near zero levels.

While the MPC has recently started to increase interest rates, they will remain very low by historical standards and substantially below the rate of inflation. This article aims to help us understand what rising inflation will mean in this low interest rate environment.

What are the links between inflation, interest rates and real economy activity?

Economics textbooks usually say that there is a key difference between anticipated inflation (inflation that was expected beforehand) and unanticipated inflation. When inflation is anticipated, transactions can be agreed, with future changes in prices taken into account. In this case, the levels of output, employment and the quantities of goods and services produced remain unaffected by the exact level of inflation.

As inflation rises, so too does the rate of lending/borrowing before considering inflation – what’s known as the ‘nominal interest rate’. This change accommodates the additional growth in prices to maintain the same overall (or real) interest rate. In simple terms, the real rate of interest is simply the nominal rate minus the inflation rate.

With anticipated inflation, if all wages and prices are perfectly flexible (meaning that they can be changed with no additional cost), then they can also be raised together with general inflation. In this case, the relative prices of goods, services and real wages will be unaffected by inflation.

In economics, this idea is known as the ‘classical dichotomy’, and it represents a theoretical benchmark that indicates conditions under which inflation will have no effect on the real economy in terms of things such as output and employment.

If this theory were applicable to the UK economy, we would expect to see the real rate of interest (the nominal rate minus the inflation rate) vary only a little – due to productivity shocks and other factors. In contrast, the nominal interest rate would vary a lot with inflation.

But in fact, at certain times, we observe the exact opposite: the real interest rate varies a lot while the nominal interest rate varies less. This has certainly been the case in the UK since 2009, when the nominal interest rate was first fixed at just above zero (with slight variation) and the real interest rate essentially mirrored this.

In this case, the real interest rate is simply the negative of the inflation rate. For economists, it is this real interest rate that matters for households and firms when they make their savings and investment decisions.

This means that the MPC policy of near zero interest rates will result in notable effects on the real interest rate as inflation varies. Even when fully anticipated, inflation will have real effects on the economy, altering consumption, investment and employment. In the period since 2009, there have been big swings in the real interest rate – from almost -5% in 2011 to just above zero in January 2015-March 2016 (see Figure 1).

Figure 1: Nominal and real interest rates, from 2009 to 2022

Source: Bank of England

This is the longest period of sustained negative real interest rates in UK history, having lasted over a decade. This has had a variety of effects on the economy, but it is the effect on the redistribution of income and wealth that is most important. Since the Second World War, there have only previously been two brief periods of negative real rates: from 1950 to 1953; and from 1974 to 1978.

What role does the central bank play?

The policy rate of interest set by the MPC is essentially a short-run interest rate, captured in the price of short-term government bonds. The other big policy used by central banks since the global financial crisis of 2007-09 has been quantitative easing (QE). This enables the central bank to influence long-term interest rates.

One of the main ways this has affected the economy is via large-scale central bank purchases of longer-term bonds. This has raised the prices of these bonds, which means that the corresponding longer-term interest rates have also fallen.

To illustrate this, Figure 2 compares the yield curves in 2010, 2018 and 2021. The yield curve shows how the interest rate (yield) on government bonds varies with the length of the bond (also called the ‘maturity’). The vertical axis shows the (nominal) return on government bonds and the horizontal axis shows the length of maturity in years.

For all three yield curves, the ‘short end’ at half a year is roughly equal to the policy rate (0.5% in 2010 and 2018, 0.1% in 2021). But the large amounts of QE undertaken between these years has ‘flattened the curve’, bringing down longer-term returns on government bonds. This has led to the real interest rates on longer-term bonds becoming negative as well as at the short end shown in Figure 1.

This means that QE has helped to bring long-term nominal interest rates down closer to zero and below the inflation rate, at least in more recent years. The combination of the MPC interest rate decisions and QE has been to make both short- and long-term real interest rates negative.

Figure 2: UK yield curves in 2010, 2018 and 2021

Source: Bank of England

Note: Since 2010, QE has 'flattened' the yield curve. While the 'short end' is around 0.5 for both 2010 and 2018, the longer end has gone down. 20 years maturity went from 4.5% in 2010 to 2% in 2018, and 1.2% in 2021

One of the major effects of flattening the yield curve has been to boost asset prices, including the stock market and house prices. In general, there is an inverse relationship between the rate of interest and the value of financial assets: lower interest rates mean higher asset prices.

For example, if an asset yields £10 per year, its market value is approximately equal to £10 divided by the interest rate, which gives the amount you would need to invest at that interest rate to give you an income of £10. Using this approximation, if the interest rate was 10%, you would only need to invest £100 to give you an income of £10 per year. If the interest rate is 0.5% – as it has been most of the time – the income of £10 per annum is worth £2,000. Whether the income is from rent, dividends or bonds, the income generated by the asset is worth more when interest rates are lower.

This also has real effects, since the ownership of assets is highly skewed with a small proportion of households owning most of the wealth. Wealth inequality has increased in the UK in recent years.

What are the effects of inflation when there are near zero or fixed interest rates?

So, how does inflation affect the economy in an environment where nominal rates are fixed, as they have been since 2009? There are several effects, even when inflation is anticipated.

First, higher inflation redistributes from lenders to borrowers. With a fixed nominal interest rate, inflation reduces the amount that borrowers have to repay to lenders overall (in real terms). If one person has borrowed £100 from another, and promised to repay £105 in 12 months’ time, the actual value of the eventual £105 will depend on inflation (if prices have gone up, £105 is less valuable).

If inflation over the 12 months is equal to 5%, then the £105 that the borrower has to repay has the same purchasing power as the £100 initially borrowed a year ago. This implies a zero real interest rate. If there had been no inflation, then the real interest rate would have been 5%. If interest rates were operating normally, this effect would be present only if the inflation was not fully anticipated.

Second, the government is the biggest borrower in the UK, with debt equal to almost 100% of GDP. There is therefore a big ‘inflation tax’. The real value of the governments’ liabilities declines, which is in effect a tax levied on the holders of government bonds. If I own bonds that promise to pay me £1,000 next year, the purchasing power of that £1,000 will be less as a result of inflation.

For example, if inflation was 5%, my purchasing power available from the £1,000 will be 5% less (because the items I consume have gone up in price). I will be in exactly the same position as if there had been no inflation and I had been taxed directly on the bond payment.

Due to QE, a large proportion of the UK government debt is held by the Bank of England. But the Bank’s bond purchases are ultimately funded by the creation of reserves at the Bank held by commercial banks. These are liabilities of the public sector to commercial banks, so that inflation erodes their value in the same way as it does bonds held by the private sector and households.

The size of the inflation tax is very large given the high level of debt relative to GDP. The Bank of England expects inflation to reach over 10% in 2022, so the inflation tax will be equivalent to about 10% or more of GDP.

Note that the inflation tax on bonds relies on the fixed interest rate policy. If interest rates were free to adjust, then they would rise with inflation so that the real return on bonds was not affected: the additional interest payments on the bonds would compensate for the extra inflation.

Third, this inflation tax does not fall on financial intermediaries such as banks, because both their assets and liabilities will generally be defined in nominal terms: inflation will reduce the value of their assets (bonds, reserves at the Bank of England) and their liabilities (deposits of firms and households).

Exceptions to this are defined benefit pension schemes, where the liabilities are defined in real inflation-indexed terms and the bonds held are nominal. Any assets or liabilities that are indexed to inflation will not be subject to the inflation tax.

Ultimately, the bulk of the inflation tax is levied on households indirectly, even if they do not directly own government bonds. This is because the broad measure of money (known as M4) takes the form of household deposits at commercial banks. The value of this money held by households is eroded by inflation.

So, in the fixed interest rate environment that has been in place since 2009, inflation has big effects even if fully anticipated. It redistributes purchasing power from savers to borrowers. Savers are hit as the real return on their savings declines and becomes negative. Households with mortgages will benefit as the real cost of their loans falls. But the biggest beneficiary of all is the government, since the value of its debt will decline in real terms and there is in effect an inflation tax.

What are the other effects of inflation?

There are several more standard costs to inflation, even when interest rates are not fixed. The most important ones in the current situation are the following.

Eroding purchasing power

Inflation erodes the real value of wages and benefit payments. If these are set in nominal terms, the process is obvious. Over time, the fixed nominal income is able to buy less if prices are going up. Now, benefits and the minimum wage may be indexed to inflation, in the sense that each year they are updated as a result of last year’s inflation. An increase in inflation will still have an effect: since the indexation is lagged and not instantaneous, real income will be falling until the minimum wage or benefit is updated.

For example, if I have an income of £100 per week, if inflation is 5%, then each month my income will fall by about 0.42% (5% divided by 12 months). But at the end of the year, if it is indexed it will be updated by 5% to take it back to its original level in terms of purchasing power. But in the intervening months, the real value of that income has been declining.

Wages may in principle rise faster than inflation, leading to a rise in real wages. But if inflation is higher than was expected when the wages were agreed, the unexpected inflation will still reduce real wages below the expected value. Where nominal wages are inflexible downwards, inflation might be the natural method of reducing real wages in response to some negative effect.

Informational costs

Inflation reduces the information conveyed by prices in terms of the relative costs of different items, and so may lead to a misallocation of resources. Prices are going up and down all the time. The Consumer Prices Index (CPI) measures the inflation of a basket of over 700 items covering most household expenditures. When inflation is low, most of the changes reflect real changes in relative prices.

But when inflation is higher, the public may confuse nominal price changes and real (relative) changes. People may be put off buying a good or service when its price goes up because they think it has gone up relative to other goods when it has not.

Further, if inflation leads to more uncertainty about relative prices, it will lead households to devote more time to researching prices – sometimes called the ‘shoe leather’ cost of inflation.

Higher costs of holding money

Inflation introduces a cost of holding money (at least for non-interest bearing deposits). This means that it erodes the ability of money to act as a store of value. When inflation is very high, households may be driven to holding other assets that are more volatile, such as gold or Bitcoin, or substituting foreign currency (for example, the US dollar) for the domestic currency. It should be noted that this flight from money usually only happens in a hyper-inflation.

Indeed, in his theory of the optimal quantity of money, Milton Friedman argued that to encourage people to hold money, the inflation rate should be negative (so that there was a real return to holding money). The role of money as a store of value is very important and encourages savings. This role is undermined by inflation.

Great uncertainty

Inflation creates uncertainty, which discourages investment by firms since the returns to investment become less predictable. This uncertainty also makes households worse off. In essence, higher inflation can lead to households and firms putting a higher probability of a bad outcome.

History tells us that when inflation is prolonged, it becomes entrenched and then it is hard and costly to reduce it. If higher inflation becomes part of firms’ and households’ expectations, then inflation can become hard-wired into wage and price decisions.

The costs of curbing these inflationary expectations will come in the form of low growth and unemployment, as illustrated by the big recessions of the 1980s in the UK and the United States when the ‘Great Inflation’ of the 1970s was reversed.

What are the implications for monetary policy?

Prior to 2009, the MPC set interest rates above the rate of inflation nearly all of the time. Inflation almost always remained in the target range of 1-3% from 1993 onwards, with average inflation at exactly 2%.

This was a period of active inflation targeting, where the nominal interest rate was kept above the inflation rate and varied to keep inflation on target. Inflation expectations settled down at 2% from the mid-1990s as the private sector came to trust that the Bank of England was willing and able to keep inflation at this long-run average.

Since 2009, the priorities of the MPC have shifted away from inflation and more towards supporting the recovery. Inflation has swung around more wildly: from 0% to 5%, but still with an average around 2%.

Until 2020, inflation expectations have remained anchored. But now there is something of a moment of truth for the MPC. Inflation looks set to rise to 10% or possibly more in 2022. If the Bank of England keeps interest rates at these very low levels, then the private sector will lose faith in the Bank’s willingness and ability to control inflation and keep it low.

But the Bank may be a prisoner of circumstances. It is ultimately subordinate to the elected government and the chancellor faces a very high level of government debt. If the Bank were to raise interest rates, this would have a negative effect on government finances. Also, low interest rates have led to high asset prices, not just in bond markets but also in the housing and stock markets.

Raising interest rates might well lead to a decline in the values of these assets, which would be very unpopular with the wealthy and homeowners. This means that the Bank may be unwilling and unable to raise interest rates significantly.

Indeed, although current expectations for inflation are close to or above double digits in Europe and North America, markets expect interest rates to stay at levels well below inflation and below their levels before the global financial crisis of 2007-09.

Such a situation is sometimes referred to as ‘Japanification’, in reference to Japan’s experience since 1990. Given the testing fiscal situation of many economies, perhaps inflation will be the inevitable outcome of an inability of central banks to raise interest rates and governments to raise taxes or cut expenditures.

The war in Ukraine and ensuing sanctions imposed by the West have only made matters worse in terms of policy choices of central banks and governments by making the supply side of the economy worse.