Can rising interest rates really control inflation?

Treating inflation with high interest rates is like treating cancer with chemotherapy. You have to kill swathes of the economy to slow things down. Illustration: Collected


Treating inflation with high interest rates is like treating cancer with chemotherapy. You have to kill swathes of the economy to slow things down. Illustration: Collected

Russia’s military attack on Ukraine has unquestionably unbalanced the global economy. The newspapers are full of stories about the long-term impact of this war. Obviously, I agree with many of the dire predictions being made, but for this article I have chosen to address another equally burning and long-term issue: the role of rising interest rates. Simply put, it revolves around the question, “How high should the interest rate rise to curb inflation?”

We know that the rate of interest determines the price of holding or lending money. Banks pay an interest rate on savings to attract depositors. Banks also receive an interest rate for money lent from their deposits. When interest rates are low, individuals and businesses tend to borrow more from banks, thereby increasing the money supply. As a result, inflation rises. On the other hand, higher interest rates tend to lower inflation.

Although this is a very simplified version of the relationship, it highlights why interest rates and inflation tend to be inversely correlated.

Economists are increasingly concerned that the interest rate borrowers are paying will soon skyrocket and short-circuit the post-pandemic economic recovery. So why is the interest rate going up? How does it affect other macroeconomic variables, notably the price level? Can rising interest rates really curb inflation? I cannot answer all of these questions here for lack of space, but I hope to pique the interest of readers so that they can delve deeper into the puzzle over time.

A central bank can use changes in interest rates as a tool to fight inflation. It does this by fixing the commercial banks’ short-term borrowing rate – known as the repo rate in Bangladesh – and then these banks pass it on to consumers and businesses. This rate influences everything from credit card interest to mortgages and auto loans, making borrowing more expensive. On the other hand, it also increases savings and certificate of deposit (CD) rates and encourages savings.

During a period of inflation, a central bank aims to make borrowing more expensive so that consumers delay their purchases, thereby cooling demand and controlling prices. The biggest challenge is finding the right level so as not to raise it too high, which will stifle investment and hurt the poor.

As we see now, interest rates in countries around the world are rising after a lull in recent years. The Bank of England has started raising interest rates from historic pandemic lows and is under increasing pressure to raise the bank rate again. The US Federal Reserve is expected to begin raising the benchmark rate, known as the funds rate, at the next Board of Governors meeting on March 15-16. The European Common Bank may selectively raise rates, and there is no doubt that Asian countries will follow, although there may be a slight lag.

The novelty of this upward trend is that many central banks in North America and Europe have cut their respective interest rates to near-zero levels in an effort to meet the maximum stability targets for the economy. employment and prices. Unfortunately, inflation has recently spiked due to rising demand and supply chain bottlenecks. Central banks have now decided to curb aggregate demand and money supply to ease inflationary pressures.

The crucial question here is whether the observed movement in the two variables – interest rate and inflation – exhibits causality, or is it just coincidence? The question is immediately relevant: will the simple increase in the interest rate bring down the rate of inflation? Also, how high and how fast must the interest rate rise to have an impact on inflation? For example, if necessary, can the Fed raise interest rates to 5%, 10% or, as in the 1980s, 20%? Is it even calculable or predictable in advance? The answer to these questions is no.

Raghuram Rajan, former chief economist of the IMF and governor of the Reserve Bank of India, called interest rates a “brutal” tool in a situation where the real culprit is the creaky supply chain. The interest rate is a blunt tool also because aggregate price indices do not tell us precisely what prices are changing, for what reasons or with what effect.

“The government should take steps to protect the poorest through tougher price caps and direct financial support, while increasing investment in green projects to end our exposure to fossil fuel price volatility. and curbing demand from those who can afford it through wealth taxes,” Rajan said. adds.

Of course, it will take some time before any action taken by a central bank will have an impact on the economy and curb inflation. That’s why policymaking groups need to watch economic data carefully to decide how much and how often to raise rates.

And the biggest challenge is finding the optimal level of interest rate increases without plunging the economy into a slump. Treating inflation is like treating cancer with chemotherapy, as one expert once said. “You have to kill chunks of the economy to slow things down. It’s not nice treatment.”

Dr Abdullah Shibli is a senior research fellow at the US-based International Institute for Sustainable Development (ISDI).

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