The policy of raising interest rates followed by the central banks of the USA (Fed) and the European Union (EU) puts at risk the growth rate of the economies, without being at all certain to help contain inflation. And this happens because of the kind of inflation we have, that is, because of its origin.
The inflation we face today comes not from excess demand driving up prices, but from supply disruption.
External conditions such as the pandemic and war have led to supply chain problems and shortages of products and raw materials in the West. In addition to the curtailment of production and trade caused by COVID-19 and the war in Ukraine, we also have a very large increase in the cost of transporting products due to an increase in freight rates. Barriers to trade routes, combined with reduced production, push up prices and cause inflation in Western economies.
Inflation has always been central banks’ main problem. In the US the Fed’s charter obliges it to be concerned with maintaining price stability and the pursuit of full employment. The ECB’s statute does not include the objective of employment, but only price stability, i.e. its job is to deal with inflation. The executives of the central banks, therefore, are in conditions of enormous stress because they have to do something to justify their position.
In this context, central banks raise interest rates, a move that would theoretically curb inflation – if it came from excess demand, but not that from a lack of supply.
But no matter how much it raises interest rates, the ECB will not stop the war in Ukraine and shortages will exist, so gas prices will be high, so will grain prices, so will fertilizer prices and of animal feed.
The causes of inflation we are facing now are not affected by rising interest rates. Of course, interest rate increases may indirectly reduce demand because they cause factory closings and recession. In this case we need less natural gas and less chemicals, since our factories will be closed. We will therefore consume less, but what we will consume we will pay at the high prices and not at the lower ones. The benefit is uncertain, perhaps non-existent, while the damage has been done, recessions have occurred and factories have closed, unemployment has risen and incomes have fallen.
It’s no coincidence that the US stock market didn’t fall when the Fed announced a bold 0.75% dollar rate hike (which investors expected and accepted), but fell a few hours later when its chairman said he wouldn’t hold back to sacrifice growth rate to deal with inflation. At that moment the American stock markets were well into the red. This shows the moods and view of the market. That he accepts some controlled rise in interest rates for the Fed to justify its existence, but does not accept driving the economy into recession to deal with inflation.
Inflation, deficits and debt are necessary to control, but it is not at all good to treat them like sacred cows. Addressing these three economic scourges in an absolute manner damages both societies and the economy.
Inflation that runs at tolerably high levels for a period of time, say two years, does not cause much damage to the economy, quite the opposite. What are the tolerable high levels? Inflation of, say, 5% or 7% does not scare anyone but central banks. Instead, it helps reduce the debt of countries as a percentage of GDP, of businesses and households as a percentage of their income, increases the nominal growth rate and provides opportunities for wage growth. If interest rates don’t rise, businesses will survive and their workers will keep their jobs. Demand may be slightly reduced due to higher prices, and so will their profits, but everyone will survive and avoid recession.
If interest rates rise, the benefits of debt relief are reversed and debt – which is already a global problem and extremely high by current standards, at least for some EU countries – increases, the profits of those businesses that survive disappear and many businesses close, sending workers into unemployment. Also, households are struggling to pay their loans and new bad loans are being created on bank balance sheets.
The moment is difficult for all economies, especially European ones, and the institutions that control and direct economies, such as central banks and finance ministries, are going through difficult times.
But since the current situation is not an ordinary one and the known ways of dealing with inflation do not seem to fit the situation in question, central bankers may have to abandon the blindfold method of dealing with the problem.
Perhaps the right choice today is to do nothing and let inflation go where it will and stabilize at even higher than tolerable levels until the war ends and the supply problems are solved. This way we will have a period of high inflation, but the debt as a percentage of GDP will have been reduced, without sacrificing the growth of the economy and jobs.
All this, of course, assuming that the supply disruptions created by COVID-19 and the war in Ukraine stop – which is a reasonable expectation. Because if the war does not end and expands, the two years of inflation may become five or ten. The world wars, again, when they ended brought enormous growth.
