Interest rates

Will rising interest rates really stop inflation?

The big question is: do higher rates actually add to inflationary pressures? Will this blunt instrument succeed in the present circumstances?

Contrary to expectations that rates would stay low for another two or three years, central banks are suddenly pursuing aggressive hikes. These rises follow the inability to predict post-lockdown price increases. Rate hikes may turn out to be too small, too late. Bankers may find that the current economic difficulties appear against the backdrop of more nuanced issues.

As a saver, I obviously welcome better returns and I also welcome any policy that stops inflation. However, I fear that central banks may find that tightening monetary policy is not as effective in achieving their goals this time around.

Economic instability

Instead, their actions could trigger economic instability, even higher inflation with more rate hikes to come. This economic time bomb coincides with a rush towards the great “green” energy transition which will undoubtedly cost us all extremely dearly. Far from helping the poorest in society, going “green” will deepen inequalities, lower living standards and frustrate the aspirations of ordinary people. It’s a matter of economics versus ideology.

Under normal circumstances, rate hikes aim to suppress demand by capping discretionary spending. Working families, the middle classes and their wage envelopes are often seen as sacrificial lambs when it comes to fighting inflation. But it often does not end well as it creates industrial unrest, social unrest, strikes and protests.

My concern is that rate hikes will not resolve supply factors such as those ongoing post Covid-19. They are not equipped to do so. These supply-side issues will continue to persist as long as China continues its aggressive zero-zero approach to Covid-19. Then we have to deal with geopolitical events, resource scarcity and climate change. The rate hikes won’t remove sanctions on Russia either. They are already having a massive effect on food and energy supply and costs. We can say to whom these sanctions hurt the most.

Feed inflation

Paradoxically, high interest rates can actually fuel inflation. Basically, it’s just another added burden. Many businesses have been forced to borrow more during the pandemic, citing low borrowing costs as justification. But with refunds now costing much more, as usual, companies will have no recourse but to pass on the increased spending to consumers. All of this, along with higher mortgage payments, adds up to higher wage demands. It’s a vicious inflationary circle.

Rate fluctuations can also affect currencies. The devaluation of local currencies increases the cost of importing goods, including fuel, to these territories. During the 1980s and early 1990s, a combination of recessions, high inflation and very high interest rates negatively impacted manufacturing and drove much of it offshore. Particularly to low-wage Asian economies where much of it has remained. While export-driven manufacturing has absolved much of the West from emissions responsibilities, it has also created last-minute supply chain structures that are now massively compromised.

inflation bubble

I believe central banks are still languishing in the belief that high interest rates burst the inflation bubble of the 1980s. What is perhaps not so widely remembered is all the other measures that played an equally important role, such as deregulation which weakened the power of unions. Distant India, China, Eastern Europe and Russia have been drawn into an increasingly globalized trading system providing cheap labor and plentiful commodities at low prices. All of this served to reduce the cost of Western goods and services. The result was three whole decades of gloriously low inflation. Party time!

But what we have done is massively enrich these countries, especially China. As a result, China has created a huge middle-class consumer society of its own. China is now actively competing for the resources and commodities it once sold to us. The tides have turned. They wanted what we had and they got it in a frighteningly short time!

Closer to home, central banks have contributed to the inflationary spiral. Initially, banks cut interest rates to protect depositors. They were supposed to prevent the general collapse of the financial system in 2008. Since then, central banks have shown a persistent reluctance to bring rates back to normal levels. They therefore helped to fan an inflationary tsunami. Abnormally low interest rates over an extended period of time drove house prices up dramatically and even fueled a property boom. Considering that housing plays such a big role in how inflation is measured, it’s a wonder inflation didn’t show up much sooner than it did.

Quantitative easing

Add to this rancid witch brew the rather complex role of quantitative easing. Central banks have effectively financed governments by buying debt. This money has often been squandered, resulting in record global debt levels with some governments already mired in impossible financial quagmires. Alarmingly, some may not be equipped to bear higher interest charges. The European Central Bank is trying to contain the effect of rising rates on highly exposed member states such as Italy.

Household finances are clearly under increasing threat. Asset price positivity, including stocks, repos and real estate, was based on the assumption that low interest rates would persist. While real interest rates remain very low in historical terms, recent increases have seen equities fall by as much as 20%. An increase of 0.25% to 0.50% is in fact equivalent to a 50% increase, while a hypothetical increase of 10% to 11% is only a 10% increase in real terms, although it is a percentage point increase as opposed to fractions. It also means that real estate values ​​are also under pressure. Even Crypto currencies suffered staggering losses.

Low interest rates have lubricated investment channels to developing countries. But today, rising rates, rising energy and soaring food prices are proving to be a problematic environment for emerging markets that have been important trading partners for the West. Interest rate hikes have been a key driver of historic financial crises in both Asia and Latin America. It seems that boom and bust cycles continue to haunt our global outlook.

Governments and central banks will no doubt one day proclaim their victories against the specter of inflation. Statistics are often micromanaged. However, in reality, if the price of a loaf of bread increases from €1 to €1.20, this is equivalent to a 20% increase. If, however, the price stays at €1.20 the next time it is measured, there is zero price inflation. Brilliant news! Meanwhile, back at the ranch, the actual cost of living will not have gone down one iota since bread will still cost €1.20.

So. However, interest rate hikes could eventually produce an economic slowdown. This will in turn impact already decelerating economic activity and even longer-term employment prospects. As with most interventions, the laws of unintended consequences could kick in, triggering financial market turbulence (which is already happening to some extent). Central bankers will eventually be forced to backtrack and possibly cut interest rates again and pump even more money into the economy, revisiting the same old territory.

The opinions expressed on this page are those of the author and not of The Portugal News.