- The world economy is on the brink of outright recession, according to the International Monetary Fund (IMF). The Ukraine war and sanctions have scuttled recovery from the COVID-19 pandemic.
Over 80 central banks have already raised interest rates so far this year. Except for the Bank of Japan governor, major central bankers have reacted to recent inflation by raising interest rates. Hence, stagflation is increasingly likely as rising interest rates slow the economy, but do not quell supply-side cost-push inflation.
IMF U-turn unexplained
The IMF chief economist recently advised, âInflation at current levels represents a clear risk for current and future macroeconomic stability and bringing it back to central bank targets should be the top priority for policymakersâ.
While acknowledging the short-term costs of raising interest rates, he has never bothered to explain why inflation targets should be considered sacrosanct regardless of circumstances. Simply asserting inflation will be more costly if not checked now makes for poor evidence-based policy making.
After all, only a month earlier, on 7 June, the IMF advised, âCountries should allow international prices to pass through to domestic prices while protecting households that are most in needâ.
The Fund recognized the major sources of current inflation are supply disruptions â first due to pandemic lockdowns disrupting supply chains, and then, delivery blockages of food, fuel and fertilizer due to war and sanctions.
US Fed infallible?
Without explaining why, US Federal Reserve Bank Chair Jerome Powell insists on emulating his hero, Paul Volcker, Fed chair during 1979-87. Volcker famously almost doubled the federal funds target rate to nearly 20%.
Thus, Volcker caused the longest US recession since the 1930sâ Great Depression, raising unemployment to nearly 11%, while âthe effects of unemployment, on health and earnings of sacked workers, persisted for yearsâ.
Asked at a US Senate hearing if the Fed was prepared to do whatever it takes to control inflation â even if it harms growth â Powell replied, âthe answer to your question is yesâ.But major central banks have âover-reactedâ time and again, with disastrous consequences. Milton Friedman famously argued the US Fed exacerbated the 1930sâ Great Depression. Instead of providing liquidity to businesses struggling with short-term cash-flow problems, it squeezed credit, crushing economic activity.
Jomo Kwame Sundaram
Similarly, later Fed chair Ben Bernanke and his co-authors showed overzealous monetary tightening was mainly responsible for the 1970sâ stagflation. With prices still rising despite higher interest rates, stagflation now looms large.
North Atlantic trio
Most central bankers have long been obsessed with fighting inflation, insisting on bringing it down to 2%, despite harming economic progress. This formulaic response is prescribed, even when inflation is not mainly due to surging demand.
Powell recently observed, âsupply is a big part of the storyâ, acknowledging the Ukraine war and Chinaâs pandemic restrictions have pushed prices up.
While admitting higher interest rates may increase unemployment, Powell insists meeting the 2% target is âunconditionalâ. He asserted, âwe have the tools and the resolve to get it down to 2%â, insisting âweâre going to do thatâ.
While recognizing âvery big supply shocksâ as the primary cause of inflation, Bank of England (BOE) Governor Andrew Bailey also vows to meet the 2% inflation target, allowing âno ifs or butsâ.
While European Central Bank President Christine Lagarde does not expect to return âto that environment of low inflationâ, admitting âinflation in the euro area today is being driven by a complex mix of factorsâ, she insists on raising âinterest rates for as long as it takes to bring inflation back to our [2%] targetâ.
Much of the problem is due to the 2% inflation targeting dogma. As the then Governor of the Reserve Bank of New Zealand â the first central bank to adopt a 2% inflation target â later admitted, âThe figure was plucked out of the airâ.
Thus, a âchance remarkâ by the NZ Finance Minister â during âa television interview on April 1, 1988 that he was thinking of genuine price stability, âaround 0, or 0 to 1 percentââ â has become monetary policy worldwide!
Powell also acknowledged, âSince the pandemic, weâve been living in a world where the economy has been driven by very different forcesâ. He confessed, âI think we understand better how little we understand about inflation.â
Meanwhile, Powell acknowledges how changed globalization, demographics, productivity and technical progress no longer check price increases â as during the âGreat Moderationâ.
Baileyâs resolve to get inflation to 2% is even more shocking as he admits the BOE cannot stop inflation hitting 10%, as âthere isnât a lot we can doâ.
Although it has no theoretical, analytical or empirical basis, many central bankers treat inflation targeting as universal best practice â in all circumstances! Thus, despite acknowledging supply-side disruptions and changed conditions, they still insist on the 2% inflation target!
Interest rate, blunt tool
Central bankersâ inflation targeting dogma will cause much damage. Even when inflation is rising, raising interest rates may not be the right policy tool for several reasons.
First, the interest rate only addresses the symptoms, not the causes of inflation â which can be many. Second, raising interest rates too often and too much can kill productive and efficient businesses along with those less so.
Third, by slowing the economy, higher interest rates discourage investment in new technology, skill-upgrading, plant and equipment, adversely affecting the economyâs long-term potential.
Fourth, higher interest rates will raise debt burdens for governments, businesses and households. Borrowings accelerated after the 2008-09 global financial crisis, and even more during the pandemic.
Monetary tightening also constrains fiscal policy. A slower economy implies less tax revenue and more social provisioning spending. Higher interest rates also raise living costs as householdsâ debt-servicing costs rise, especially for mortgages. Living costs also rise as businesses pass on higher interest rates to consumers.
The recent inflationary surge is broadly acknowledged as due to supply shortages, mainly due to the new Cold War, pandemic, Ukraine war and sanctions.
Increasing interest rates may slow price increases by reducing demand, but does not address supply constraints, the main cause of inflation now. Anti-inflationary policy in the current circumstances should therefore change from suppressing domestic demand, with higher interest rates, to enhancing supplies.
Raising interest rates increases credit costs for all. Instead, financial constraints on desired industries to be promoted (e.g., renewable energy) should be eased. Meanwhile, credit for undesirable, inefficient, speculative and unproductive activities (e.g., real estate and share purchases) should be tightened.
This requires macroeconomic policies to support economic diversification, by promoting industrial investments and technological innovation. Each goal needs customized policy tools.
Instead of reacting to inflation by raising the interest rate â a blunt one-size-fits-all instrument indeed â policymakers should consider various causes of inflation and how they interact.
Each source of inflation needs appropriate policy tools, not one blunt instrument for all. But central bankers still consider raising interest rates the main, if not only policy against inflation â a universal hammer for every cause of inflation, all seen as nails.
IPS UN Bureau