The figure plots average inflation against average nominal interest rates for 41 developed countries for a sample covering 1961 through to 2016. The fit to a line with unitary slope is remarkably good. The average of these variables is thus unambiguous about a positive, virtually one-for-one relationship between inflation and nominal interest rates. 

The mechanism behind this relation is not incompatible with the standard logic behind the policy of stimulating the economy and raising inflation by reducing nominal rates.  Over the short run the stimulus results from price rigidities, such that a decrease in nominal interest rates implies a decrease in real interest rates (i.e., nominal rates minus inflation). Over the long-run real interest rates are determined by structural features of the economy such as the growth of productivity and demographics, which are outside the control of central banks. 

One consequence is that if nominal rates stay persistently low the stimulative effect eventually fades away, as it cannot be that real rates are persistently kept low. This means that inflation tends to be lower. These insights can be relevant in view of the ongoing monetary policy debates in the euro area.

For additional detail, refer to Valle e Azevedo, Ritto e Teles (2019): “The Neutrality of Nominal Rates: How Long is the Long Run?”, Banco de Portugal Working Paper, No. 11/2019.

Prepared by João Valle e Azevedo. The analyses, opinions and results expressed above are those of the author and do not necessarily coincide of those of Banco de Portugal or the Eurosystem. 

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