The Economy

Inflation is a monetary phenonomenon. It literally is just the money supply being expanded (or inflated). We have a fiat currency that isn't backed by anything tangible and scarce, so it has led to politicians running huge debts and a central bank being called on to monetize that debt (to keep enabling it, otherwise it wouldn't be possible).

So. ... Interest rates are the cost of money. In a free market, millions of lenders and borrowers would be determining what the cost of money should be. They'd make individual decisions that are informed by how the economy is performing (and therefore how likely borrowers are to default), how risky what the borrower wants the money for is, etc. We don't have a free market. We have a price-fixing authority that dictates the cost of money. ... again, always setting the cost way below where the free market would have set it organically, because that is what politicians running huge debts require. To answer your question, all things being equal, when the cost of money is higher, it reduces the money supply (credit contracts), because the higher cost of money restrains borrowing. THAT should be deflationary.

The thing is, all things aren't equal. The quaint days of a central bank trying to manipulate the debt markets by controlling short-term interest rates were blown to smithereens over the last couple of decades. They started to actively intervene in the debt makets when the debt mess their manipulation created became too big for them to contol without a heavier hand. That led to things like quantitive easing and the Repo / Reverse Repo market / and one-off interventions like their Bank Term Funding Program when banks started to fail last year, where they buy debt with money they create out of thin air (and without regard to price) to have flooded the economy with new money. It's why the growth of M2 money supply has looked like this:



One other thing. ... People equate inflation with the effect on consumers prices. But the inflation itself is the constant creation of new money (which dilutes the value of the existing money). The effect of that money supply growth can be unpredictable, but it always leads to later problems in one way or another. Throughout the era of quantitative easing you see in the graph, they acted like they were geniuses who were creating free economic growth (which was really just a shit ton of debt creation) without spurring "inflation" (even though they needed to change "stable prices" to a made-up 2 percent higher prices every year 'target' as consumer prices did take off). But all of that money they flood the economy with doesn't necessarily find its way entirely into the price of Cheerios. With the mechanism they used throughout the 2000s -- quantitative easing -- they were basically funneling the "free money" they unleashed to rich people (those who already had wealth), which in turn led to speculation in risk assets -- excess things that rich people can afford. That is inflation, too. It led to bull markets in bonds AND stocks as yields were driven down and more and more money drove up stock prices. People thing that is good because, "look at my 401(K)." Or "look at the appreciation in my home value!" But the world has a long history with this. ... there is no free lunch. It's all being driven by debt (money being mispriced), which creates underlying financial instability. It's what led to everything from Tulipmania to the Great Depression to the Financial Crisis in 2008, and in the latest binge, the amount of debt and expansion of the money supply has gone well beyond anything the world has ever seen.

The last few years, everyone has been focused on consumer price inflation, and it's easy to see now that the reason the "inflation" effected consumer prices so much was that with the pandemic our government ratcheted up its debt spending and did things that funneled a lot of that that freshly "printed" money to non-rich people too. Where the line goes vertical on the graph during the pandemic, our central bank was really expanding the money supply to monetize all of the debt behind that. ... and that is the inflation (as people use the term) that got of the genie bottle. The Fed's overnight rate is a piece of it, but in reality a very small piece. ... They have been more than counteracting the higher short-term interest rates with what they are doing with their reverse repo program. Banks are choking on the money the Fed is sending their way right now, which is why stock prices which were losing value reversed last year after higher rates started to pop the bubble.