– Inflation hawks are winning the day. The latest ‘beggar thyself’ race to raise interest rates has begun. This ostensibly responds to the spectre of runaway inflation, supposedly retarding economic growth and progress, and thus threatening central bank ‘credibility’.
Inflation fetish
The ‘one size fits all’ policy of raising interest rates to contain inflation is being touted again, the world over. This will surely kill national efforts to revive economies reeling from COVID-19 pandemic slowdowns.
Central banks in many emerging market and developing economies (EMDEs) – such as Brazil, Russia and Mexico – began raising policy interest rates right after inflation warning bells were set off after mid-2021. Indonesia and South Africa have since joined the bandwagon.
International Monetary Fund (IMF) Managing Director Kristalina Georgieva has warned that US interest rate rises would “throw cold water” on global recovery, especially hurting struggling emerging markets.
An earlier IMF blog had urged EMDEs to prepare for earlier than expected US interest rate hikes. The Fund has lowered its growth projections as the inflation bogey induces monetary and fiscal tightening.
Inflation paranoia
Inflation hawks denounce price increases, claiming – without evidence – that it impedes growth. Former World Bank chief economist Michael Bruno and William Easterly refuted these popular, but false prejudices.
Using 1962-1992 data for 127 countries, they found, “The ratio of fervent beliefs to tangible evidence seems unusually high”. They also found extremely high inflation – over 40% yearly – mainly due to very exceptional circumstances, e.g., Nicaragua after the Sandinista takeover.
Bruno and Easterly concluded that inflation under 40% did not tend to accelerate or worsen. They concluded, “countries can manage to live with moderate – around 15–30 percent – inflation for long periods”.
Bank economists Ross Levine, Sara Zervos and David Renelt confirmed a negative inflation-growth relationship to be exceptional, and due to a few extreme cases.
Rudiger Dornbusch and former IMF Deputy Managing Director Stanley Fischer came to similar conclusions. They too found moderate inflation of 15–30% did not harm growth, emphasizing “such inflations can be reduced only at a substantial short-term cost to growth”.
Citing IMF research, Harry Johnson also argued that while very high inflation could be harmful, there was no conclusive empirical evidence of the alleged inflation-stagnation causal nexus.
Even monetarist guru Milton Friedman acknowledged, “Historically, all possible combinations have occurred: inflation with and without development, no inflation with and without development”.
Thus, the Fund and the Bank have no sound bases for promoting draconian policies to eliminate inflation above, say 5%, by citing a few exceptional cases of very high, runaway inflation and low growth.
Inflation misdiagnosed
Friedman’s sweeping generalization that “inflation is always and everywhere a monetary phenomenon” ignored other factors possibly contributing to inflation.
Without careful consideration of inflation’s causes, the same old policy prescriptions are likely to fail, but not without causing much harm. Prices tend to rise as demand outstrips supply. This can also happen when demand rises faster than supply, or if demand does not decline when supply falls.
The IMF attributes the current inflationary surge to supply chain woes, higher energy prices and local wage pressures. While demand has been boosted by pandemic relief and recovery measures, where existent, supply shortages remain vulnerable to disruptions.
Rising food costs are also pushing up consumer prices. Extreme weather events – droughts, fires, floods, etc. – have affected food output. More commodity price speculation – e.g., via indexed futures – has also raised food prices.
Although wages have risen in some sectors in some countries, economy-wide wage-price spirals are unlikely. Employment suffered during the pandemic while unionization is at historically low levels.
Labour’s collective bargaining powers have declined for decades, especially with technological change, casualization and globalization lowering the labour income share of GDP.
As the profit share of income continues to rise, rising mark-ups and executive remuneration also push up prices. With more market monopoly powers, price gouging has become more widespread with the pandemic.
Understanding what causes particular prices to rise is critical for planning appropriate policy responses. Although devoid of actual diagnoses, inflation hawks have no hesitation prescribing their standard inflation elixir – raising interest rates.
Raising interest rates may help if inflation is mainly due to easier credit fuelling demand. But tighter credit is unlikely to effectively address ‘supply-side’ inflation, which typically requires targeted measures to overcome bottlenecks.
Interest rates harm
Higher interest rates increase borrowing costs, squeezing investment and household spending. This hits businesses, hurting employment, incomes and spending, and can result in a vicious downward spiral.
Higher interest rates also increase governments’ debt burdens, forcing them to cut spending on public services including healthcare and education. Incredibly, elevated interest rates – harming investments, jobs, earnings and social protection – supposedly benefits the public!
The adverse spill-over impacts of rising interest rates are also considerable. Raising rates in major advanced economies weaken EMDE capital inflows, currencies, fiscal positions and financial stability, especially as sovereign debt has ballooned over the last two years.
Indeed, the interest rate is a blunt weapon against inflation. How can raising interest rates curb food or oil price increases? While supply blockages persist, essential consumer prices will rise, even with high interest rates.
Higher interest rates may even aggravate inflation as businesses cut investment spending. Thus, supply bottlenecks, especially of essential goods, are likely to be more severe, pushing up their prices.
Most people are indebted, with the poor often borrowing to smoothen consumption. Thus, the poor are hurt in many ways: losing jobs and earnings, coping with less social protection, and having to borrow at higher interest rates.
Hence, the standard medicine of higher interest rates has massive social costs. Meanwhile, the principal beneficiaries of using higher interest rates to lower inflation are rich net creditors and financial asset owners.
Toxic prescription
Premature reversal of expansionary fiscal policy has been largely due to debt hawks’ successful fear mongering. Thus, debt paranoia nipped in the bud the ‘green shoots’ of robust recovery following the 2008-2009 global financial crisis.
In the early 1980s, inflation paranoia led to interest rate spikes, triggering debt crises, stagnation and lost decades in much of the world, especially developing countries. Now, inflation hawks are poised to derail global recovery, stop adequate climate action and otherwise undermine sustainable development.
Policymakers the world over, but especially in developing countries, must reject the inflation hawks’ paranoid screeches. Instead, they must identify and address the sources, causes and nature of the inflation actually faced. And then, take appropriate measures to prevent inflation accelerating to harmful levels.
There are a host of alternative policy measures available to policymakers. They must reject the lie that they have no choice but to raise interest rates – widely recognized as a blunt weapon, with deadly ‘externalities’.
While all available policy options may involve trade-offs, policymakers must seek and achieve socially optimal results. This requires robust, resilient, green and inclusive recoveries – not fighting quixotic windmills of the paranoid mind.
