Aug. 27, 2008

Inflation Fight with Inflation-Indexed Interest Rates

One problem with traditional monetary tools is that as inflation heightens, real interest rate falls, which actually fuels inflation because inflation reduces expected real interest rates. Central banks have then to raise interest rates, but with inflation expectations uncertain, how much nominal interest rates need to be raised is not clear. As a result, there is a tendency for gradualism, as central banks need to take one step at a time and watch what happens. It is anybody's guess as to where the interest rate hike is going to reach, and conversely when interest rates are to fall, it is anybody's guess as to where the interest rate decline is going to end up.

With a currency anchored to the WCU, or with indexed instruments, however, real interest rates will not fall when inflation rises. So there is an automatic check against borrowing on the assumption that inflation will relieve real borrowing cost. With a currency anchored to the WCU or with monetary policy directly determining real interest rates using indexed instruments, therefore, the inflation fight will be easier.

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