Could consumer price inflation be caused by higher rates?

Woody spends much of his time tutoring A-level students in economics and hence has to spend quite a lot of time pretending that standard theory about growth and inflation is adequate. However now that the exams are finished he can suspend belief for the time being and instead try to make sense of what is going on.

And the question that struck me was: could it be that the inflation in consumer prices that we are experiencing is the result of tighter credit conditions, rather than excessively loose ones as one would normally suppose?

My thought process went as follows.

When monetary conditions were loose, it didn't alter the demand for consumer goods very much because demand for them isn't that income elastic. (Richer people don't really spend that much more on petrol or food.) But loose monetary conditions reduced the costs for firms making and selling consumer goods, so that supply grew and prices therefore remained pretty low. Instead people spent more on housing which is highly income elastic. So loose monetary policy created house price inflation and consumer price disinflation / deflation. So far so good.

Now that monetary conditions have tightened substantially (a higher base rate + a higher risk premium demanded by lenders), this dynamic has reversed. People's demand for food, oil, and consumer goods hasn't altered all that much (because it's income inelastic). But the cost to firms of making and selling those products has risen sharply as borrowing costs have risen. Hence supply has fallen, but demand has stayed roughly the same - causing prices to rise. And the reverse has happened in housing. Higher borrowing costs have caused demand for housing to fall and supply to simultaneously rise - leading to falling prices.

So I tried to gather some data to check whether this might show up. I put together the chart at the top which shows how LIBOR and CPI have changed over the past few years. There is a pretty close correlation, but (and Woody might well be imagining this), the major trends appear to occur in LIBOR first, then some months later in the CPI. If so, then the current increase in CPI may have been caused by the spike in LIBOR caused by the credit crunch towards the end of 2007.

If this is right it suggests that the standard AS / AD approach to growth and prices fails to appreciate that in the modern economy - particularly for goods not usually financed through borrowing - the effect of higher borrowing costs may be more powerful on AS than it is on AD in the short run, hence having a perverse effect on prices.

Perhaps once the falling housing market hits demand in the wider economy, leading to unemployment, lower investment and lower consumer confidence, then but only then you get a fall in demand that outstrips the fall in supply caused by the higher borrowing costs. Then you get deflation / disinflation.

So maybe tighter monetary policy in the short-term leads to consumer price inflation, but in the medium-term to consumer price deflation. If this is right it suggests that CPI will indeed fall in the next year as a result of the fall-back in LIBOR, but won't fall substantially until LIBOR goes much lower.

Oh dear, what will Woody tell the kids?