Episode 123: Why Does Raising Interest Rates Curb Inflation? — If It Increases Costs, Why Do Prices Fall?

I was thinking about the Bank of Japan’s interest rate hike recently, and one thing bothered me.
It is often said that
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if you raise interest rates, corporate and household spending will decrease, and inflation will be curbed.
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But when you think about it carefully, it seems a bit strange.
If interest rates rise, the burden of home loans increases.
Corporate borrowing costs also rise.
The government’s interest payment burden also increases.
In other words,
everyone’s costs are going up.
Even so, why can inflation be curbed?
Thinking about this, the meaning of the policy of raising interest rates became a little clearer.
Raising interest rates is not a “policy to lower costs”
First, to clarify, raising interest rates is not a policy to lighten the burden on companies and households.
It is actually the opposite.
It intentionally makes the cost of borrowing money higher.
For companies,
borrowing interest rates rise
↓
the profitability of new factories and capital investment worsens
↓
they postpone investment a little
is what happens.
For households,
home loan interest rates rise
↓
the hurdle for purchasing a home rises
or, if they have already borrowed with a variable interest rate,
repayment amounts increase
↓
money available for other expenses like dining out, travel, and cars decreases
is what happens.
In other words,
raising interest rates itself does not directly lower prices.
It slightly suppresses corporate and household spending,
cooling the demand of the entire economy.
If demand weakens, companies also find it harder to continue raising prices.
This is the basic mechanism by which raising interest rates curbs inflation.
In other words,
raising interest rates is a policy that cools demand by increasing costs.
It is easy to understand if you think of it that way.
Therefore, raising interest rates naturally involves “pain”
Thinking this far,
“if there is inflation, we should just raise interest rates more”
cannot be said so simply either.
While raising interest rates curbs inflation, it also causes:
borrowing burdens for companies.
home loan burdens for households.
financing costs for real estate.
interest payment burdens on government bonds for the government.
Especially in Japan, the government’s debt balance is large.
If interest rates rise, the government’s interest payment expenses will also increase as government bonds are sequentially refinanced.
Also, if you raise interest rates when you want companies to increase investment, it becomes a headwind for capital investment.
Therefore, for those considering policy, it becomes a difficult balance of:
wanting to curb inflation,
but not wanting to raise interest rates so much that it destroys the economy.
But not raising interest rates enough is also a problem
Conversely,
“then we should just not raise interest rates”
is not the case either.
If Japanese interest rates remain low while US interest rates are high, the interest rate gap between Japan and the US will remain.
Then,
borrowing funds in yen at a low interest rate and investing in overseas assets that can expect a higher yield
makes a yen carry trade easy to establish.
Borrow yen.
Sell yen.
Buy dollars, etc.
Channel those funds into overseas assets.
Such movements tend to work in the direction of a weaker yen.
In fact, the Bank of Japan raised its policy interest rate to 1.25% on September 18, but the yen remained weak afterward, falling to the 157 yen per dollar level on September 21. In the market, it was noted that the Bank of Japan’s decision was 7 to 2 and that no strong path for future additional interest rate hikes was indicated.
If the yen weakens further, the import prices of crude oil, food, etc., will rise.
Japan’s imports in August also increased by 28% year-on-year against the backdrop of high crude oil prices.
In other words,
raising interest rates too much → the economy, investment, households, and finance suffer
on the other hand,
not raising interest rates enough → a weak yen and import inflation suffer
is the structure.
Both are problematic.
Then wouldn’t it be better to raise them by 0.125% at a time?
So I thought.
The Bank of Japan this time
raised interest rates from 1.00% to 1.25%,
by 0.25%.
Then,
wouldn’t it be better to raise them by 0.125% at a time?
1.25%
↓
1.375%
↓
1.50%
↓
1.625%
and raise them in small increments.
That way, you could tighten the financial environment little by little while minimizing the shock to companies and households.
The logic seems plausible.
In fact, there is no rule that a central bank must change interest rates in 0.25% increments.
Looking at the world, there are examples of policy interest rates being moved by different widths, such as 10bp or 35bp.
Then why is 0.25% often used?
0.25% is not a “law,” but closer to a common language of the market
At major central banks, 25bp, or 0.25%, has become established as a standard unit.
Therefore, market participants also often predict in the form of
“will it be a hold or 25bp next?”
What is important here is that
it is not simply decided that “0.125% will not convey seriousness.”
For example,
if the market expects a hold → and in reality it is a 0.125% interest rate hike,
it is actually hawkish.
Conversely,
if the market expects a 0.25% interest rate hike → and in reality it is 0.125%,
it may be perceived as “more cautious than expected.”
In other words, the market is looking at
the difference from the forecast, not the percentage raised itself.
Furthermore, the market is looking at the “next” time rather than “this” time
The Bank of Japan raised rates by 25bp this time.
Even so, the yen did not rise.
This is interesting.
If you think about it normally,
Japanese interest rates rise
↓
the Japan-US interest rate gap narrows
↓
a stronger yen
seems likely.
But in reality, the yen weakened.
One reason is that
I think the market is looking ahead, not at the 25bp this time.
The Bank of Japan raised rates to 1.25%.
However, the US policy interest rate is 3.75–4.00%.
The Fed itself also leaves open the possibility of additional interest rate hikes.
In other words, from the market’s perspective,
Japan also raised rates.
But the interest rate gap with the US is still large.
Furthermore, the Bank of Japan did not strongly fix the pace at which it will raise interest rates in the future.
Then,
the expectation that “Japanese interest rates will not rise rapidly from now on” remains.
Therefore, it is thought that the yen carry trade did not go as far as to be unwound all at once.
The yen carry trade is not the “protagonist” but an “amplifier”
The yen carry trade is also easy to misunderstand.
It is not that all yen depreciation and stock price increases are caused by the yen carry trade.
However,
it can become a force that amplifies the direction of the market.
For example,
AI demand is strong.
US stocks are rising.
US interest rates are high.
Japanese interest rates are relatively low.
The yen is weak.
If these conditions are met, transactions using the yen as a funding currency are likely to continue.
Conversely,
the Bank of Japan raises interest rates more than expected.
The Fed heads toward interest rate cuts.
The Japan-US interest rate gap narrows rapidly.
The yen surges.
If that happens,
there is a possibility that movements to buy back the yen and sell risk assets will occur simultaneously.
Therefore, it is easy to understand the yen carry trade as
an amplifier that magnifies movements, not the sole cause of creating the market’s direction.
Japan’s monetary policy cannot be seen just by “whether to raise interest rates”
Thinking this far,
the initial
“if there is inflation, we should just raise interest rates”
story looks quite different.
Certainly, if you want to curb inflation, monetary tightening is one method.
But raising interest rates is
not a policy to directly lower prices.
It is a policy to weaken inflationary pressure by increasing the financing costs of companies and households and cooling demand.
Therefore, the side effects are also large.
Moreover, in Japan,
the economy,
corporate investment,
home loans,
government interest payments,
the yen exchange rate,
import prices,
and the yen carry trade
are all connected.
The problem is not “whether to raise them” but “at what speed and how far to raise them”
At first,
it was a simple question: “wouldn’t it be better to raise them by 0.125% instead of 0.25%?”
But as I thought about it,
whether it is 0.125% or 0.25% was not the essence.
What the market is looking at is
how many bp were raised this time.
What is the difference from the market forecast?
Will they raise them next time too?
At what speed will they raise them?
Where will they ultimately go?
How will the Fed move?
As a result, what will happen to the Japan-US interest rate gap?
is the overall picture.
Monetary policy is
not a binary choice of raising interest rates or not.
And it is
not just about whether it is an accelerator or a brake.
What is truly difficult is
how hard to press the brake,
when to ease it,
and where to stop.
I think that is it.
Raising interest rates curbs inflation.
But the mechanism is
not to lower costs, but to intentionally increase costs.
When you understand that,
why Japan finds it difficult to raise interest rates rapidly,
and why the yen sometimes does not rise even if rates are raised by 25bp,
became a little easier to see.