Why does Raising Interest Rates Halt Inflation?
There’s currently some debate about whether raising interest rates is an effective method of reigning in surging inflation. Well, we can clearly look back to the example of the late 1970s and early 1980s when Paul Volker, then United States Federal Reserve chief, raised interest rates in the United States to a dizzying 20% to truly stamp out inflationary pressures, driven by energy crises in both 1973 and also 1979, as well as the backdrop and impact of the Vietnam War. And, going further back in history, to post-war Germany, we have the example of the Weimar Republic, where soaring inflation resulted in the German mark being dropped altogether, and replaced with barter (trading cigarettes etc). In fact, in the period from 1919 to 1923 — post World War I — inflation was so stark that the cost of one loaf of bread went from around 160 marks to 200 billion marks in a single year.
Returning to economic fundamentals, a key component of inflation is monetary inflation. This is different to some of the pressures we are currently facing due to the war in the Ukraine and the associated sanctions against Russian fossil fuel exports (coal, oil, natural gas etc), which are driving up energy costs. Monetary inflation is simply the level of cash in an economy, which is regulated by central banks. One of their primary jobs is to regulate inflation, as well as support the economy in general. In recent years, just like in the aftermath of the 2008 Great Financial Crisis, we saw massive monetary inflation, in the form of economic stimulus packages, such as the furlough schemes that were brought into place in an effort to stave off a massive deflationary spiral during the economic lockdowns of the COVID-19 pandemic — shown here by this historical gold price chart from Kitco.
Of course the huge monetary inflation of the late 2000s was largely a result of the massive publicly funded financial institution bailouts, which differs from the crisis we are witnessing today. In fact the current situation has more in common with the persistent ‘stagflation’ of the 1970s and the associated energy crises. And, as i’ve covered previously, energy costs underline all costs in the economy — from transport costs, to food costs, clothing prices, consumer electronics prices etc. However the disconnect we are seeing at the moment between energy cost inflation and labour cost inflation is creating profound difficulties for people all around the world, exacerbated by food shortages due to the war in the Ukraine. And despite some modest efforts to increase minimum wage levels, such as here in the UK, generally speaking most people are earning less money than in previous years due to the high levels of inflation we are currently witnessing.
So where do interest rates come in? Well, put simply, increasing interest rates decreases demand for goods and services. This is particularly effective these days, where interest-free — or simply low interest-rate — loans have been used to entice consumers to buy expensive consumer electronics, brand new high spec cars, and even new homes.
It also puts pressure on consumers to pay down existing debts, especially in respect of loans without a fixed rate of interest and credit card repayments. Furthermore it has a profound effect on stock markets, where investors and, in particular, investment banks and hedge funds, are forced to close down trades and try to shrink their balance sheets - to adjust their risk profile to the new market environment. This is formally known as ‘deleveraging’, and is a key component of why some central bankers thought that the inflation we are seeing would be only ‘transitory’. In reality, the monetary inflation was just too high, and it’s still not clear how long the inflationary spiral will continue, and how high the costs of goods and services will reach.
So, what now? Well, energy costs continue to soar. Central banks, including the US Federal Reserve, the Bank of England and the European Central Bank (ECB) are beginning to make unprecedented interest rate hikes. Time will only tell how effective they are, and if they need to continue. Of course, the balancing act of tackling inflation whilst not pushing the economy into an economic recession is no easy task. And, in the meantime, calls for energy tax cuts are only growing — something I outlined and advocated for in my previous article.
