Higher rates are expected to reduce the level of demand in an economy because existing debt becomes more expensive to service, so people have less to spend on other things and less incentive to take on debt to make purchases.
That would be expected to cause demand to drop and move into line with the existing level of supply, dramatically reducing inflation.
Reducing demand in that way would be expected to have a negative effect on both the general level of economic growth in an economy and on the level of unemployment, the latter because businesses will reduce their supply of goods and services in response to the falling demand.
The economic theory underpinning the notion that as rates rise, so does unemployment is known as the Phillips curve, and the US data indicates that right now “it looks like the theories are not holding up”, says Schroders chief economist Keith Wade.
“We have seen rates rise in the US, and we have seen that come through as a fall in inflation, but we have not seen unemployment rise,” he adds.
But Wade believes that the fall in inflation so far has been the result of the unwinding of some of the pandemic-era supply shortages as supply has caught up with demand, reducing price pressure in the economy.
He says that the impact of interest rate rises has not been felt in the economy yet, and this is why growth has remained robust and unemployment low.
Unemployment may need to rise
Many economists take the view that there is a lag between rates rising and the impact being felt in the real economy.
Wade says the that lag may be longer on this occasion because interest rates were so low when they began to increase, and that it took several rates rises to have any material impact.
US inflation is around 3 per cent, which is above the Federal Reserve’s target of 2 per cent, and he believes that for the target to be met unemployment will have to rise, and economic theory will be validated.
That the current data is an aberration is also the view of Modupe Adegbembo, an economist who covers the G7 at Axa Investment Managers.
She says: “The bulk of the impact of rate rises has not passed though into the wider economy yet.”
Caldwell says the higher inflation has not so far had a negative impact on growth because consumers in the US had received large cheques from the government and built up considerable sayings, which enabled consumers to keep spending even as prices rose. This meant companies were able to maintain their revenues and profits, even as inflation rose, and this has delayed and distorted the usual impact of higher interest rates.
