Higher interest rates may not slow inflation, and central banks are partly to blame | Satyajit Das

CContrary to previous assurances that interest rates would remain low through 2024, the Reserve Bank of Australia’s aggressive policy—run by central banks worldwide—follows a failure to predict rising prices and may not be effective in achieving of her purpose.

Instead, the actions of the reserve bank could result in a combination of economic instability, inflation and rising interest rates – coinciding with intense power competition and a difficult energy transition – that will exacerbate inequality, weaken living standards and frustrate ordinary people’s expectations.

Why Interest Rates May Not Slow Inflation?

Designed to reduce demand by slowing discretionary spending, higher interest rates will be offset by billions of dollars in federal government spending and tax offset payments. State governments, such as New South Wales and Victoria, have announced major spending programs. Even when these initiatives target critical infrastructure and cost of living, they add to demand, which effectively contradicts the efforts of the RBA.

In addition, higher interest rates cannot address supply-side factors such as Covid-19, especially China’s dynamic zero approach, as well as geopolitical events, trade restrictions, resource scarcity, climate change and the powerful oligopolies in certain industries with pricing power. Nor will they change sanctions against Russia that affect food and energy supplies and costs.

Higher interest rates can fuel inflation. Companies, many of which borrowed heavily during the pandemic, will pass higher costs on to consumers. Rising mortgage costs are contributing to wage demands. Higher interest rates transfer cash from borrowers to lenders, which increases demand for goods and services and prices when spent.

In addition, they can have adverse currency effects. With local interest rates lagging in the US, the Australian dollar has fallen about 10% against the US currency since 2021, raising the cost of imported goods. Higher rates and a devalued currency affect businesses, especially those that rely on imported items. In the 1980s, a recession, inflation and high interest rates made production difficult in the US and drove the production exodus to Asia.

Central banks believe that high interest rates defeated the inflation monster of the early 1980s in the US. While this was one factor, other influences were important, most notably deregulation of many industries and weakening of union power. The integration of China, India and Eastern Europe and Russia into the global trading system produced cheap labor and raw materials, reducing the cost of goods and services. The low inflation of the past three decades may reflect these one-off factors, many of which are now reversing.

How central banks contributed to the problem

While they were initially correct in cutting interest rates to protect savers and avoid the collapse of the financial system in 2008, the reluctance of central banks to normalize interest rates in a timely manner contributed to inflationary pressures. Abnormally low rates pushed up house prices and encouraged investment in owner-occupied homes. Given that housing accounts for about 20% of inflation measures in most countries, it is surprising that inflation did not show up sooner. Since 2009, central banks have repeatedly used quantitative easing to finance governments by buying up their debt, allowing for often wasteful and misdirected spending.

Low rates and abundant money have previously led to record high global debt and overstretched government, business and personal finances, which may not be able to withstand higher interest costs. The European Central Bank is struggling to contain the effect of higher rates on highly indebted member states such as Italy.

There is a threat to family savings. Prices of assets, including stocks and homes, assumed low rates would persist. While interest costs remain low historically, recent increases have led to a 15% to 20% drop in inventories. House prices are under pressure. Crypto currencies have suffered losses of about US$2 trillion (AU$2.8 trillion), more than the value of Australia’s output every year.

Low rates stimulated excessive investment flows to developing countries. Higher interest rates, a strong US dollar and high energy and food costs are problematic for emerging markets, which are important trading partners for developed countries such as Australia. Interest rate hikes were a factor behind the Latin American crisis of the 1980s and the Asian crisis of 1997/98. Sri Lanka’s economic collapse is unlikely to be the last.

Central banks will at some point announce victory in their battle against rising prices. Statistically, inflation measures are changing. If oil rises from $100 to $110, that’s a 10% increase. If it stays at $110, then it’s zero. Unfortunately, the cost of living will not fall as the price of oil remains at $110. Even this is a pyrrhic victory.

Rising interest rates can cause a slowdown, especially if the government is simultaneously rebuilding budgets. This will reduce the already slowing economic activity and employment and create other turbulence. Central bankers will then change course, switch from arsonist to firefighter, cut interest rates and pump money to support the economy in a repeat of the cycle. But will the unelected central bankers be held accountable for their decisions and associated collateral damage?

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