“If your only tool is a hammer, every problem looks like a nail”. Still haunted by the clever preaching of monetarist guru Milton Friedman’s ghost, all too many monetary authorities address every inflationary threat or sign they see by raising interest rates.
Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” still defines the orthodoxy. Despite changed circumstances in the world today, for Friedmanites, inflation must be curbed by monetary tightening, especially interest rate hikes.
No central banker consensus
The threat of higher inflation has risen with Russia’s Ukraine incursion and the punitive Western ‘sanctions from hell’ in response. International Monetary Fund (IMF) Managing Director Kristalina Georgieva warns wide-ranging sanctions on Russia will worsen inflation.
European Central Bank (ECB) President Christine Lagarde fears, “The Russia-Ukraine war will have a material impact on economic activity and inflation”. US Treasury Secretary Janet Yellen has also acknowledged the new threat.
She recognizes tighter monetary policy could be contractionary, but expresses confidence in the Federal Reserve’s ability to balance that. Meanwhile, US Federal Reserve chair Jerome Powell has pledged to be “careful”.
Terming Russia’s invasion “a game changer”, with unpredictable consequences, he stressed readiness to move more aggressively if needed. On 16 March, the Fed raised its benchmark short-term interest rate while signalling up to six more rate hikes this year.
But other central bankers do not agree on how best to respond. Bank of Japan Governor Kuroda has ruled out tightening monetary policy. He recently noted, “It’s inappropriate to deal with [cost-push inflation] by scaling back stimulus or tightening monetary policy”. For Kuroda, an interest rate hike is inappropriate to deal with inflation due to surging fuel and food prices.
Friedman’s disciples at some central banks began tightening monetary policy from mid-2021. The Reserve Bank of New Zealand, the first to adopt strict inflation targeting in 1989, raised interest rates in August for the second time in two months.
The Bank of England (BOE) raised interest rates for the first time in more than three years in December. Going further, Norway’s central bank doubled its policy rate on the same day.
Anticipating interest rate rises in the US and under pressure from financial markets, central banks in some emerging market and developing economies (EMDEs) – such as Brazil, Russia and Mexico – began raising policy interest rates after inflation warning bells went off in mid-2021. Indonesia and South Africa joined the bandwagon in January 2022.
With inflation surging after the Ukraine incursion, the Bank of Canada doubledits key rate on 2 March – its first increase since October 2018.
The ECB has a more hawkish stance, dropping its more cautious earlier language. Its governing council has reiterated an old pledge to “take whatever action is needed” to pursue price stability and safeguard financial stability.
Following the US Fed’s move, the BOE raised its interest rate the next day. A month before, in February, the BOE Chief Economist was against raising interest rates, favouring a more nuanced approach.
However, instead of kneejerk interest rate responses, Reserve Bank of Australia’s Governor Philip Lowe is “prepared to be patient” while monitoring developments.
EMDE central bankers have also responded differently. Brazil has raised its benchmark interest rate after the Fed, and signalled more increases could follow this year. But Indonesia has been more circumspect.
Interest rate not inflation cure-all
The interest rate is a blunt policy tool. It does not differentiate between activities facing rising demand and those experiencing supply disruptions. Thus, interest rate hikes adversely impact investments in sectors facing supply bottlenecks needing more investment.
In short, the interest rate is indiscriminate. But the prevailing policy orthodoxy of the past four decades does not differentiate among causes of inflation, prescribing higher interest rates as the miracle ‘cure-all’.
This monetarist policy orthodoxy does not even recognize multiple causes or sources of inflation. Most observers believe that current inflationary pressures are due to both demand and supply factors.
Some sectors may be experiencing surging demand while others are facing supply disruptions and rising production costs. All this has now been exacerbated by the Ukraine crisis and the ensuing sanctions interrupting supplies.
Old lessons forgotten
Well over half a century ago, the UN’s World Economic Survey 1956 warned, “A single economic policy seems no more likely to overcome all sources of imbalance which produce rising prices and wages than is a single medicine likely to cure all diseases which produce a fever”.
Addressing ‘cost-push’ inflation using measures designed for ‘demand-pull’ phenomena is not only inappropriate, but also damaging. It can increase unemployment significantly without dampening inflation, warned the UN’s World Economic Survey 1955 as Friedman’s anti-Keynesian arguments were emerging.
Interest rates do not discriminate between credit for consumer and investment spending. In efforts to dampen demand sufficiently, interest rates are raised sharply. Such monetary tightening can do much lasting economic damage.
Declining or lower investment is harmful for the progress needed for sustainable development, requiring innovation and productivity growth. After all, improved technologies typically require new machines and tools.
No one ‘one size fits all’
Dealing with ‘stagflation’ – economic stagnation with inflation – caused by multiple factors requires both fiscal and monetary policies working together complementarily. They also need particular tools and regulatory measures for specific purposes.
Monetary authorities should also create government fiscal space by financing unanticipated urgent needs and long-term sustainable development projects, e.g., for renewable energy.
Governments need to first provide some immediate cost of living relief to defuse unrest as food and fuel prices surge. This can be done with measures that may include food vouchers, suspending some taxes on key consumer products.
In the medium- to long-term, governments can expand subsidized public provisioning of healthcare, transport, housing, education and childcare to offset rising living costs. Such public provisioning – increasing the “social wage” – diffuses wage demands, preventing wage-price spirals.
Such policy initiatives brought down inflation in Australia during the 1980s without causing large-scale unemployment. This contrasted with the deep recessions in the UK and USA then due to high interest rates.
Get correct medicine
But to do so, governments need more fiscal space. Hence, tax reforms are critical. Progressive tax reforms – such as introducing wealth taxes and raising marginal tax rates for high income earners – also mitigate inequality. Governments also need to align their short- and long-term fiscal policy frameworks.
Monetary authorities need to apply a combination of tools, such as reserve requirements for commercial bank deposits, more credit, including differential interest rate facilities, and more inclusive financing.
For example, central banks should restrict credit growth in ‘overheated’ sectors, while expanding affordable credit for those facing supply bottlenecks. Central banks also need to curb credit growth likely to be used for speculation.
Governments also need regulatory measures to prevent unscrupulous monopolies or cartels trying to manipulate markets and create artificial shortages. Regulatory measures are also needed to check commodity futures and other speculation. These increase food and fuel price rises and other problems.
Relying exclusively on the interest rate hammer is an article of monetarist faith, not macroeconomic wisdom. Pragmatic policymakers have demonstrated much ingenuity in designing more appropriate macroeconomic policy responses – not only against inflation, but worse, the stagflation now threatening the world.
IPS UN Bureau