What You Should Know About Inflation

The maintenance of short-term interest rates at too low a level, by governments or central banks, is one of the main explanations of the continuance of inflation in Europe and in the United States. Excessively low rates always encourage overborrowing, which means an expansion in the supply of money and credit, which in turn causes commodity prices to rise even further.

It is possible, of course, for a government or a central bank to keep money rates low for a long time, either by printing money directly or by permitting the overborrowing and consequent expansion of credit to which excessively low money rates inevitably lead. What is less well understood is that cheap money cannot be continued indefinitely. It sets in motion forces that eventually drive interest rates higher than if a cheap-money policy had never been followed.

The expansion of money and credit that is necessary to hold interest rates down also raises commodity prices and wages. Higher commodity prices and wages make it necessary for businessmen to borrow correspondingly more in order to do the same volume of business. Therefore the demand for credit soon increases as fast as the supply. Later on, still another factor comes in. When both borrowers and lenders begin to fear that inflation is going to continue, prices and wages begin to go up more than the increase in the supply of money and credit. Borrowers want to borrow still more to take advantage of the expected further rise in prices, and lenders insist on higher interest rates as an insurance premium against expected depreciation in the purchasing power of the money they lend.

When this happens in an extreme degree, we get a situation like that in Germany in November of 1923, when rates for “call money” went up to 30 per cent per day. This phenomenon in mild degree became evident in Britain in 1957. When the U.S. Treasury 2½ s were trading around 86 in June of 1957, for example, the British Treasury 2½s issued in 1946 could be bought at 50, or half the original purchase price. Yet corporate shares in Britain had been bid up to levels where returns to the investor were in many cases substantially lower than on gilt-edge bonds. As one London investment house explained the matter: “The argument is, indeed, put forward that, since the pound has been depreciating in the past decade at an average rate of 4¾ per cent per annum, any investment likely to show a total net return on income and capital accounts over a given period of less than this amount is giving a negative yield and should be discarded.”

The attractions of easy money were coming to an end. That is why, in September 1957, the Bank of England raised its discount rate to 7 per cent.