Interest rates

Raising interest rates to curb inflation goes against growth

Rise in inflation

By Tapiwa Gomo

Sometime in June 2020, at the height of the COVID-19 pandemic, the World Bank warned that the rapid and massive impact of the coronavirus pandemic and the shutdown measures to contain it would plunge the global economy into a severe contraction. And that was to lead to a massive global recession, probably the worst after World War II.

The reasons for the warning were simple. These are lessons to be learned from the Spanish post-influenza pandemic which was marked by the economic recession of 1920-21 characterized by extreme deflation before an economic boom and a baby boom. The reaction to these lessons is that if countries can avoid economic recession, they can bounce back easily and faster.

Another reason is that during the current COVID-19 pandemic, economic activity has contracted as domestic demand and supply, trade and finance have been severely disrupted or halted. These have left many sectors of the economy badly affected. The COVID-19 pandemic is still here with us, but its threat is proven to be slowly diminishing and with the scaling up of vaccination, most of the measures to contain its spread have been eased. This has seen most economies open cautiously.

But there is widespread fear that massive inflation is upon us and about to hit global and emerging economies. The response was a general increase in interest rates under his control. Since mid-2021, most major emerging economies such as the United States of America, United Kingdom, India, Indonesia, South Africa, Russia, Brazil, Mexico and others have started raising interest rates to protect their economies from the anticipated global crisis. inflation.

Is this generally the right direction to take and what is the relationship between interest rates and inflation?

There is an underlying assumption that rising or falling interest rates in an economy will stimulate saving or spending. Raising interest rates is thought to increase the cost of borrowing for commercial banks, encouraging them to raise their own interest rates, which should ultimately generate higher returns for consumers. savers.

But it is the opposite for the borrower. A higher cost of borrowing decreases demand and economic activity.

Technically, the prices of goods and services are rising and some global economies like the United States are already experiencing price increases of up to 40%.

Consumers are discouraged from spending by high prices, which slows growth.

For example, if a home loan becomes more expensive, consumers may decide to keep their money in their savings account. If more cash is held in bank accounts and less spent for fear of losing value due to inflation, the money supply will shrink, reducing the demand for goods and services. Additionally, companies may also decide to postpone expansion plans and delay the hiring of additional employees. This is the downside of an interest rate hike even if the economic scorecard looks balanced.

Of course, central banks have some political merit in that reduced demand slows inflation. Interest rate increases have an effect on the prices of goods and services. And if prices rise, demand falls throughout the economy. This is believed to reduce or slow down inflation. How? ‘Or’ What? If the price of an asset rises due to rising interest rates, its demand should fall. In order for the seller to sell the asset, he is forced to either wait for the customer who can afford it or reduce the price of the asset. This means that the seller must deal with reduced profit margins or reduced sales to stay in business. Businesses – the engine of the economy – are suffering, but from the central bank’s perspective, this will be seen as an effective way to fight inflation.

On the other hand, the reduction in interest rates lowers the cost of borrowing for banks, which encourages them to lower their own interest rates, thereby reducing interest on savings accounts and loans. Technically, borrowing and spending are more attractive for economic growth than saving because they stimulate the money supply and induce high spending on goods and services.

Are these measures really necessary? This is a difficult question to answer given that it is currently just inflationary paranoia – pure speculation as none has happened. Unfortunately, consumers in countries that have already raised rates are paying for this speculation with already rising commodity prices. And even if inflation does occur, it can easily be managed without unnecessarily disrupting economies.

Some economists have warned governments against taking a blanket, one-size-fits-all approach to protecting their economies from what appears to be impending global inflation by raising interest rates. They warned that a blanket approach could stifle growth mainly for economies emerging from the impact of the COVID-19 pandemic. These measures can have major and broader effects pushing millions more people into unemployment and misery on a phenomenon that can easily be tamed without major economic adjustments.

  • Tapiwa Gomo is a development consultant based in Pretoria, South Africa. He writes here in a personal capacity.