Interest Rates, Liquidity Preference and Inflation

Article of the Week from Fixing the Economists

by Philip Pilkington

On my post about Austrian and Marxian capital theory a commenter left a fairly predictable ‘Austrian comment’ which denied that they assume perfect foresight in their theory of interest rates and investment, gave a confused story about accounting identities (apparently if consumption rises then by identity profits fall; someone tell the NIPA crowd that they have it all wrong!) and insisted that I knew nothing about Austrian economics.

In the midst of this torrent of wrongness, however, the commenter made one interesting point that I haven’t heard before. He said that inflations and particularly hyperinflations proved the Keynesian liquidity preference of interest rates wrong. Here is the argument laid out in clear form.

1. Keynesian liquidity preference theory states that when liquidity preference rises interest rates will also rise as people hold onto liquid assets.
2. In a high inflation/hyperinflation environment we would expect liquidity preference to fall because the value of liquid assets is being eroded.
3. But in high inflation/hyperinflation environments we typically see interest rates rise together with the inflation.

Some sharp readers will roll their eyes at this. “Come on Phil, why are you dealing with this rubbish?” they will ask:

“Obviously in times of high inflation/hyperinflation central banks will raise the overnight rate of interest to stabilise real interest rates.”

Yes, of course this is the answer I gave to our Austrian friend and it is pretty obvious to anyone who deals with real world economic problems (as opposed to attending self-reinforcing libertarian meetings the purpose of which is to buttress a political ideology).

However, I thought that this incident might give me an opportunity to clear up some misconceptions about liquidity preference theory. You see, when we have a central bank setting the overnight rate of interest then the liquidity preference theory must be modified somewhat. Basically we must recognise that central banks have control over the interest rates but — and this is an enormous ‘but’ for anyone interested in financial markets — they do not control the spread between other interest rates and the overnight rate. This spread is dictated by liquidity preference.

In my forthcoming book I formalise this as such:

That reads as follows: the interest rate in any given market, i, is determined by the target interest rate as set by the central bank, irt, plus any transaction costs incurred from borrowing money at this rate, Tc, plus the liquidity preference in this market, Lpirt.

Thus what occurs in a high inflation/hyperinflation is quite clear. The central bank raises the target interest rate to keep up with inflation and hence keep the real interest rate stable. And the end result is that interest rates rise with inflation. This is simply a decision taken on behalf of the central bank.

So, can we gain an understanding of market dynamics in such a environment using liquidity preference theory? This is difficult in an open economy with free capital flows. If there is high inflation in such an economy many investors will hold their assets in a foreign country with low inflation. Thus the domestic decrease in liquidity preference will often be felt in another country. But in an economy with capital controls we should indeed see a clear decline in liquidity preference and a boom in the price of risky assets during very high inflations and hyperinflations.

The case of Venezuela today is a perfect example of just this. The country is in what might be called a ‘contained hyperinflation’ in that the only reason that the extremely high inflation there has not turned into hyperinflation is because the government have prevented people from moving their money abroad. What happens in such a scenario? Well, liquidity preference falls enormously and the price of domestic risky assets booms. Just look at the Caracas stock index:

Just to put that verbally: between the start of 2012 and the start of 2014 the Caracas stock index rose by over 2,300%! At the same time investors piled into any risky, non-liquid asset they could get their hands on. The property market boomed to the extent that Caracas became more expensive than London! There is the effect of crashing liquidity preference at work.

Throughout this period the Venezuelan central bank set the overnight interest rate. But here is another very interesting feature of this case study that shows just how powerful the Keynesian theory of liquidity preference is: in the past few years the Venezuelan central bank never increased the rate of interest to keep up with inflation. And guess what? It stayed far, far below said rate of inflation. The below two graphs will clearly show that there is no Fisher effect going on here.

Now, our Austrian friend was correct in that typically when we see high inflation/hyperinflation we will see interest rates rise. As we have seen he forgot to add: because central banks will typically force them to rise. But in cases where the central bank, for whatever reason, does not raise interest rates we will not see interest rates rise. The case of Venezuela today shows this beyond a shadow of a doubt.

This ties into something that I have discussed on this blog previously: namely, that central banks have full control over interest rates and that they can hold them down even as inflation soars ahead if they want to do this.

So there you have it. Liquidity preference must be understood in light of the fact that, in modern economies, the central bank controls the overnight rate of interest. Liquidity preference only dominates in the spread between this rate of interest and other rates of interest in the economy. When inflation gets out of control the central bank will typically raise the overnight rate. But this says nothing about liquidity preference theory. Finally, we had a nice opportunity to show that if the central bank doesn’t want to raise the interest rate then this interest rate will lag far behind the rate of inflation.