How does inflation affect interest rates? In the short run, central banks often play a critical role in setting short-term interest rates. For example, the Federal Reserve directly controls the Federal Funds interest rate, the rate at which banks borrow in the inter-bank market. And other short-term dollar interest rates, such as the commercial paper and Treasury bill interest rates in the United States or the LIBOR rate on dollar deposits in London, are loosely linked to the Fed Funds rate.1 So if the Fed raises the Fed Funds rate by 25 basis points, or 0.25 percent, the commercial paper and Treasury bill rates and LIBOR are likely to rise by a similar amount (in normal times, at least). In the long-run, however, the role of the Federal Reserve is very different. In the long run, U.S. interest rates are primarily determined by inflation. And it is the Fed’s role in helping to determine the inflation rate that matters.

Consider the history of U.S. interest rates since the late 1940s as shown in Figure 7.1. Except for a temporary bout of inflation during the Korean War, inflation remained low in the United States until the late 1960s and 1970s. Inflation peaked following two oil price shocks in 1973 and 1974 and 1979. Beginning in the late 1960s, interest rates slowly but surely responded to rising inflation as inflation expectations became imbedded in bond yields. The same inflation expectations led to rising wage demands and to downward pressure on the U.S. dollar. ...

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