This article first appeared in Forum, The Edge Malaysia Weekly on August 15, 2022 - August 21, 2022
The world economy is on the brink of outright recession, according to the International Monetary Fund (IMF). The Ukraine war and the resultant sanctions against Russia 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.
The IMF chief economist recently advised, “Inflation 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 policymakers.”
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 that inflation will be more costly if not checked now makes for poor evidence-based policymaking.
After all, only a month earlier, on June 7, the IMF advised, “Countries should allow international prices to pass through to domestic prices while protecting households that are most in need.”
The IMF recognised that the major sources of current inflation are supply disruptions — first due to pandemic lockdowns disrupting supply chains and then, delivery blockages of food, fuel and fertiliser due to war and sanctions.
Without explaining why, US Federal Reserve chair Jerome Powell insists on emulating his hero, Paul Volcker, the Fed chair from 1979 to 1987. Volcker famously almost doubled the federal funds target rate to nearly 20%. Thus, he caused the longest US recession since the Great Depression in the 1930s, raising unemployment to nearly 11%, while the effects of unemployment on the health and earnings of sacked workers persisted for years.
Asked at a US Senate hearing if the Fed is prepared to do whatever it takes to control inflation — even if it harms growth — Powell replied, “The answer to your question is yes.”
But major central banks have “overreacted” time and again, with disastrous consequences. Milton Friedman famously argued that the Fed exacerbated the Great Depression. Instead of providing liquidity to businesses struggling with short-term cash-flow problems, it squeezed credit, crushing economic activity.
Similarly, later Fed chair Ben Bernanke and his co-authors of a Brookings paper showed that overzealous monetary tightening was mainly responsible for the stagflation in the 1970s. With prices still rising despite higher interest rates, stagflation now looms large.
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 that “supply is a big part of the story”, acknowledging that the Ukraine war and China’s pandemic restrictions have pushed prices up. While admitting higher interest rates may increase unemployment, he insists that meeting the 2% target is “unconditional” and asserts that “we have the tools and the resolve to get it down to 2%”, insisting “we’re going to do that”.
While recognising “very big supply shocks” as the primary cause of inflation, Bank of England (BOE) governor Andrew Bailey also vows to meet the 2% inflation target, allowing “no ifs or buts”.
While European Central Bank president Christine Lagarde does not expect to return “to that environment of low inflation”, admitting that “inflation in the euro area today is being driven by a complex mix of factors”, she insists on raising “interest rates for as long as it takes to bring inflation back to our [2%] target”.
Much of the problem is due to the 2% inflation targeting dogma. As the then governor of the Reserve Bank of New Zealand — the first central bank to adopt a 2% inflation target — later admitted, “The figure was plucked out of the air”.
Thus, a “chance remark” by the New Zealand finance minister — during “a television interview on April 1, 1988, that he was thinking of genuine price stability, ‘around 0, or 0 to 1%’” — has become monetary policy worldwide!
Powell also acknowledged that, “Since the pandemic, we’ve been living in a world where the economy has been driven by very different forces.” He confessed, “I think we understand better how little we understand about inflation.”
Meanwhile, Powell acknowledges how globalisation, demographics, productivity and technical progress no longer check price increases, as they did during the “Great Moderation”.
Bailey’s resolve to get inflation to 2% is even more shocking as he admits that the BoE cannot stop inflation hitting 10%, as “there isn’t a lot we can do”.
Although it has no theoretical, analytical or empirical basis, many central bankers treat inflation targeting as universal best practice — in all circumstances. Thus, despite acknowledging supply-side disruptions and changed conditions, they still insist on the 2% inflation target.
Central bankers’ 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 — which can be many. Second, raising interest rates too often and too much can kill productive and efficient businesses along with those that are less so.
Third, by slowing the economy, higher interest rates discourage investment in new technology, skill-upgrading, plant and equipment, adversely affecting the economy’s long-term potential.
Fourth, higher interest rates will increase debt burdens for governments, businesses and households. Borrowings accelerated after the 2008 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 raise living costs as households’ 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 because of the new Cold War, pandemic, Ukraine war and sanctions.
Increasing interest rates may slow price increases by reducing demand, but it 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 (for example, renewable energy) should be eased. Meanwhile, credit for undesirable, inefficient, speculative and unproductive activities (for example, 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 customised policy tools.
Instead of reacting to inflation by raising the interest rate — a blunt one-size-fits-all instrument indeed — 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 — a universal hammer for every cause of inflation, all seen as nails.
Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former economics professor, was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.
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