Introduction
Price stability is typically defined as a low and stable rate of inflation, with most central banks, including the US Federal Reserve, targeting around 2%. Whether low interest rates achieve this depends on the state of the economy, the causes of inflation and external factors. When the economy operates below full employment, low rates can support growth without triggering excessive inflation. When the economy is close to or beyond full capacity, continued low rates may cause demand-pull inflation. Moreover, inflation can arise from cost-push factors such as supply chain disruptions or geopolitical shocks, which monetary policy alone cannot control. Low rates may therefore contribute to price stability under certain conditions but must be adjusted in response to economic conditions and external pressures.
How maintaining low interest rates may allow the US to attain price stability
The effectiveness of low rates depends on whether the economy is operating below or near full employment. When the economy is far from full employment, as during the COVID-19 pandemic in 2020 when US unemployment was around 13%, the economy operated well below capacity. Maintaining low interest rates encouraged borrowing and investment, improving business confidence and household spending. As aggregate demand increased from AD0 to AD1, real output rose from Y0 to Y1 while inflation remained stable at P0, since excess capacity prevented price pressures. As long as inflation remained at or below 2%, price stability was achieved. In a recessionary environment, low rates can raise AD and restore employment without creating excessive inflation.
When the economy approaches full employment, as in 2021 when US unemployment fell to 5.5%, maintaining low rates can fuel inflation. With businesses and consumers remaining optimistic, higher borrowing and spending drove AD from AD0 to AD1, raising output from Y0 to Y1 and prices from P0 to P1. As long as inflation remains near the 2% target, price stability is maintained despite higher output. However, if demand continues to rise from AD1 to AD2 while the economy is already near full capacity, prices may rise significantly from P1 to P2, beyond the target, making it unsustainable to maintain low rates.
How maintaining low interest rates may not allow the US to attain price stability
By the end of 2021 the US economy had largely recovered, with unemployment at 5.5% and demand still rising. Persistently low rates contributed to a further expansion of AD from AD2 to AD3, pushing prices beyond the Fed's 2% target. The Fed's decision to delay raising rates contributed to demand-pull inflation as businesses and consumers continued to borrow and spend, and by 2022 inflation had surged beyond 8%, reflecting a failure to maintain price stability. In hindsight, the Fed should have begun raising rates in 2021 to curb excessive pressures. Maintaining low rates beyond full employment therefore leads to inflation exceeding the target.
Low rates may also not be the sole cause of inflation, as external supply-side shocks can drive prices higher. The Russia-Ukraine war in 2022 raised global energy and food prices through reduced grain exports from Ukraine, increasing food costs, and oil supply disruptions from Russia, raising energy prices. These factors increased firms' costs of production, shifting short-run aggregate supply leftward and causing cost-push inflation. Pandemic-related supply chain disruptions also raised transportation costs and shipping delays and caused shortages of key raw materials. These would have driven inflation higher regardless of interest rate policy, so keeping rates low or raising them would have had limited impact on cost-push inflation. Supply-side policies such as diversifying import sources, improving logistics infrastructure and increasing domestic production would have been more effective.
Evaluative conclusion
Whether low interest rates enable the US to achieve price stability depends on the state of the economy and the causes of inflation. Below full employment, low rates can stimulate growth without excessive inflation, supporting price stability. Near full employment, keeping rates low too long can fuel demand-pull inflation, as in the US by 2022 when inflation surged beyond 8%. Inflation may also arise from cost-push factors such as supply chain disruptions and geopolitical shocks, which monetary policy alone cannot control. Therefore, while low interest rates can support price stability in certain conditions, long-term inflation control requires a combination of interest rate adjustments and supply-side measures to address structural inflationary pressures.