RDP 9104: Cross-Country Relationship Between Interest Rates and Inflation over Three Decades 1. Introduction

Casual observation of data on interest rates and inflation suggests that countries with high inflation rates also tend to have high nominal interest rates. This is not a remarkable conclusion. Fisher (1930) put forward the hypothesis that over the longer term, movements in the nominal interest rate will reflect movements in the rate of inflation one-for-one. The implication is that a country will have higher nominal interest rates if inflation (more precisely, expected inflation) is high than if it is low. Translated into predictions for interest rates across countries, a logical conclusion is that nominal interest rates will tend to be higher in countries with higher inflation.

An alternative reason why nominal interest rates might be expected to be higher in high inflation countries is to do with policy reactions. In this scenario, countries with high inflation are attempting to reduce inflation and will consequently run tighter monetary policy than low inflation countries. This implies that, over the period they are running tighter monetary policies, they will have higher real interest rates. Hence, the higher interest rates are due to a higher real component in the interest rate.

This paper takes a very simple look at the relationship between inflation and interest rates for a number of OECD countries over three decades. Unlike many previous studies in this area, there is no attempt to estimate Fisher equations for each of the countries. The paper simply presents some data and puts forward some possible explanations for the relationships found. There is no attempt to test these competing hypotheses formally. Nor does the paper intend to highlight the positions of individual countries in relation to one another. The analysis focuses exclusively on the generalised cross-country relationship.

The paper is organised as follows. First, the data are presented in graphical form and uses simple regression analysis to illustrate relationships. In this section some simple relationships are drawn out. Second, possible explanations for the observed relationships are put forward and an attempt is made to distinguish between the alternative hypotheses on the basis of the data. Finally, the conclusions are summarised.