Higher interest rates may not slow inflation, and central banks are partly to blame

·4-min read
<span>Photograph: Mark Baker/AP</span>
Photograph: Mark Baker/AP

Contrary to earlier assurances that interest rates would remain low until 2024, the Reserve Bank of Australia’s aggressive policy – being pursued by central banks globally – follows failures to forecast rising prices and may not be effective in achieving its objective.

Instead, the reserve bank’s actions may result in a combination of economic instability, inflation and rising rates – coinciding with great power competition and a difficult energy transition – which will exacerbate inequality, dilute living standards and frustrate ordinary people’s expectations.

Why interest rates may not slow inflation

Designed to reduce demand by slowing discretionary spending, higher interest rates will be counteracted by billions of dollars in federal government spending and tax offset payments. State governments, such as New South Wales and Victoria, have announced large expenditure programs. Even where these initiatives target essential infrastructure and living costs, they add to demand, effectively contradicting the RBA’s efforts.

Related: Workers and their wages are the collateral damage of the war on inflation | Greg Jericho

In addition, higher interest rates cannot address supply side factors such as Covid-19, especially China’s dynamic zero approach, as well as geopolitical events, trade restrictions, resource scarcity, climate change and the powerful oligopolies in certain industries with pricing power. They will also not alter sanctions on Russia affecting food and energy supply and costs.

Higher interest rates can feed inflation. Businesses, many who have borrowed heavily during the pandemic, will pass on increased expenses to consumers. Increasing mortgage payments add to wage demands. Higher interest rates transfer cash from borrowers to lenders which if spent increases demand for goods and services and prices.

Plus, they can have adverse currency effects. With local interest rates lagging in the US, the Australian dollar has declined against the US currency by about 10% since 2021, increasing the cost of imported goods. Higher rates and a devalued currency affect businesses especially those reliant on imported items. In the 1980s, a recession, inflation and high interest rates made manufacturing in the US difficult and drove the exodus of manufacturing to Asia.

Central banks believe that high interest rates slew the early 1980s US inflation monster. While a factor, other influences were important, particularly deregulation of many industries and weakening of union power. The integration of China, India and eastern Europe and Russia into the global trading system supplied cheap labour and commodities which lowered the cost of goods and services. The low inflation of the last three decades may reflect these one-off factors, many of which are now reversing.

How central banks have contributed to the problem

While initially correct in cutting rates to protect depositors and preventing the collapse of the financial system in 2008, central banks’ unwillingness to normalise interest rates in a timely manner added to inflationary pressures. Abnormally low rates pushed up housing prices and encouraged investment in buy-to-rent properties. Given that housing is about 20% of inflation measures in most countries, it is surprising that inflation did not emerge earlier. Since 2009, central banks repeatedly used quantitative easing to finance governments by buying their debt, often facilitating profligate and misdirected spending.

Low rates and abundant money has previously resulted in record high global debt levels and overextended government, business and personal finances, which may not withstand higher interest expenses. The European Central Bank is struggling to contain the effect of higher rates on highly indebted member nations like Italy.

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There is a threat to household savings. The prices of assets, including shares and houses, assumed low rates would continue. While interest costs remain low in historical terms, the recent rises have led to stocks falling by 15% to 20%. House values are under pressure. Crypto currencies have seen losses of around US$2tn (AU$2.8tn), greater than the value of Australian output each year.

Low rates encouraged excessive investment flows into developing countries. Higher rates, a strong US dollar and high energy and food costs are problematic for emerging markets which are important trading partners for developed countries like Australia. Interest rate rises were one factor behind the 1980s Latin American and 1997/98 Asian crisis. The economic collapse of Sri Lanka is not likely to be the last.

Central banks, at some stage, will announce victory in their battle against rising prices. Statistically, inflation measures change. If oil increases from $100 to $110, then that equates to a 10% rise. If it remains at $110, then it is zero. Unfortunately, the cost of living will not decrease as oil remains at $110. Even this is a pyrrhic victory.

Increasing interest rates may induce a slowdown, especially if the government simultaneously moves to repair budgets. This will reduce already decelerating economic activity and employment as well as setting off other turbulence. Central bankers will then reverse course, switching from arsonist to firefighter, cutting interest rates and pumping money to prop up the economy in a repeat of the cycle. But will the unelected central bankers be held accountable for their decisions and associated collateral damage?

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