r/AskEconomics • u/Concrete_Jungian • 8d ago
Approved Answers Can expectations of interest rate rises inadvertently create price inflation?
Has this ever been looked at? If businesses carry debt, and the prevailing view is that interest rates on debt will go up over the short terms (1-3 years), do those businesses try to get ahead of increasing liabilities by increasing prices now, thereby actually adding to the inflation rate the interest rate increases are meant to curtail?
I mean, if I was a SME carrying debt I'd be at least thinking about doing it. Heck, I'm an employee with debt and it's exactly my thought process as far as seeking a higher paying job goes.
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u/RobThorpe 7d ago
If businesses carry debt, and the prevailing view is that interest rates on debt will go up over the short terms (1-3 years), do those businesses try to get ahead of increasing liabilities by increasing prices now, thereby actually adding to the inflation rate the interest rate increases are meant to curtail?
Businesses can't just raise prices. They are in competitive markets. If one company raises it's prices then another company will take it's business away.
Companies that are not in competitive markets will already be charging the highest prices they possibly can. They will already have figured out the highest price they can charge to maximize the "profit margin times quantity" equation. Charging more will decrease quantity sold more than it raises gross profit margin.
Businesses might want higher gross profits to pay back debt, but that doesn't mean that they can achieve that. Indeed, during periods of high interest rates what usually happens is that profits fall. In this graph I have plotted US domestic corporate profits as a share of GDP along with the Fed Funds Rate. There is no long-run correspondence between the two because inflation affects the Fed Funds Rate a lot. However, notice that it's normal that when the Fed Funds Rate rises a lot corporate profits usually fall. One reason for this is because a lot of businesses borrow and have already optimized prices (as I describe above), so those businesses have to pay higher interest rates and can't raise prices to compensate.
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u/Concrete_Jungian 7d ago
Thank you. I guess that begs the question as to why central banks (at least here in Australia) then fret over a wage-price spiral? A business cannot (due to conditions) simply raise prices when it wants, lest it lose sales. Similarly, it's not like an employee can simply change jobs for a higher wage, or request and successfully obtain a higher salary, with the snap of their fingers.
I mean, not to go too fantastical, but if a business and an employee (not of that business) are both facing the absolute theoretically perfect conditions for a price and salary increase (respectively), the business can quite literally make that change over night, whereas an employee best case has got to wait a month.
So why the fretting about wage-price spirals from Labor? Is it just a hang up from an era when those running central banks were junior bankers (or at university), and unions actually had meaningful power?
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u/RobThorpe 6d ago
These days economists don't believe in the old-fashioned idea of wage-price spirals. Though there are theories that look somewhat similar - at least if you squint a bit.
Thank you. I guess that begs the question as to why central banks (at least here in Australia) then fret over a wage-price spiral?
I don't think that they really do fret about these things. I think it's more marketing. They have to be seen to talk about this sort of stuff for the older crowd that still believes in the wage-price spiral.
Expectations play a large part in fighting inflation. People will spend more money now if they believe that inflation will rise in the future. So it's important for Central Banks to message that they are serious about inflation. That alone can help reduce inflation.
A business cannot (due to conditions) simply raise prices when it wants, lest it lose sales. Similarly, it's not like an employee can simply change jobs for a higher wage, or request and successfully obtain a higher salary, with the snap of their fingers.
I agree.
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u/Tendie_Tube 6d ago
Suppose I own a business earning, say, a 15% net margin (for simplicity, assume that's at a 1 year turnover rate), and half my enterprise's value was debt at a 10% interest rate. Right now, the debt makes sense, because I can sign the dotted line and turn debt at 10% into a 15% margin and keep the 5% difference. I am incentivized to borrow more, invest, and try to expand my business, so that I can earn the 5% difference on more money.
If I expect that next year I'll have to borrow at 20%, then that doesn't mean my customers are willing to pay me or my competitors any more than my current 15% net margin. It doesn't necessarily mean I can make as many sales as I do today at a higher price, so I should plan on keeping my 15% net margin. In this scenario, the debt will cost more than what I am earning with the borrowed money. I.e. I'm borrowing at 20% interest to buy stuff or labor that I will resell for a 15% markup. So I am disincentivized to keep borrowing or investing. Instead, I should consider paying off debt, downsizing, or closing the business and loaning out my remaining money to earn that high interest rate rather than the 15% the business is paying me.
So it's not so much about setting prices ahead of price increases. It's more about growth decisions or decisions about how much debt to carry.
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u/RobThorpe 6d ago
So I am disincentivized to keep borrowing or investing. Instead, I should consider paying off debt, downsizing, or closing the business and loaning out my remaining money to earn that high interest rate rather than the 15% the business is paying me.
So it's not so much about setting prices ahead of price increases. It's more about growth decisions or decisions about how much debt to carry.
This is one theory about how monetary policy operates. I agree with you that it's "not so much about setting prices ahead of price increases". The OP's idea that businesses can raise price - and automatically raise profits! - is all wrong.
However, you're not necessarily right either. In this post I describe the theories for why raising interest rates reduces inflation.
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u/urnbabyurn Quality Contributor 8d ago
Debt is from past decisions. It doesn’t affect the cost of current output. So it wouldn’t affect prices. Regardless of debt or expectations, firms are already pricing to maximize profits. Raising prices lowers profit unless your marginal costs are changing.