SYDNEY and KUALA LUMPUR, May 10 (IPS) — The world is under pressure from financial interests to raise interest rates, ostensibly to curb inflation. After the US Federal Reserve started raising interest rates, more central banks did the same.
Given today’s causes of inflation, such a ‘follow the leader’ imitation of the central bank cannot stop it except by slowing economies. Worse, this meant taking huge new risks, seriously damaging the medium and long-term prospects for the global economy.
Nevertheless, “The ratio of ardent beliefs to tangible evidence seems unusually high on this subject”. Unsurprisingly, central banks are still trying to keep inflation below 2% – an arbitrary target “plucked out of thin air” due to an “accidental remark” by the then New Zealand finance minister.
Raising interest rates will derail the recovery and exacerbate the disruptions and deficits caused by the pandemic, war and sanctions. Fabio Panetta, member of the Governing Council of the European Central Bank (ECB), has noted that the eurozone is “de facto stagnant” as economic growth has nearly stopped.
As policymakers grapple with inflation, growth and well-being are exposed to enormous risks. As Panetta warns, “monetary tightening aimed at containing inflation would ultimately hamper already weakening growth.”
Interest rates are rising worldwide
In November 2021, South Africa’s central bank raised interest rates for the first time in three years on emerging markets and emerging economies.
On March 24, 2022, the Bank of Mexico raised interest rates for the seventh time in a row. On the same day, Brazil’s central bank raised interest rates to the highest level since 2017.
Without evidence or reasoning, they claim that higher interest rates will curb inflation. Their acknowledged adverse effects on recovery and growth are dismissed as unavoidably necessary short-term costs for some unspecified long-term gains.
But despite higher inflation expectations, tighter international monetary conditions and uncertainty over the war in Ukraine, the ECB and the Bank of Japan have not joined the bandwagon and have so far refused to raise key rates.
Interest rate – blunt instrument
But central bankers’ dogmatic attitudes, reflexive responses and ‘follow the leader’ behavior are not helping. Even as inflation reaches dangerous levels, raising interest rates may still not be the right policy response for a variety of reasons.
First, raising interest rates only addresses the symptoms — not the causes — of inflation. Inflation is often said to result from an ‘overheating’ of an economy. But overheating can be due to many factors.
Higher interest rates may alleviate overheating by slowing economic activity. But a good doctor must first investigate and diagnose the causes of a condition before prescribing an appropriate treatment — which may or may not require medication.
It is widely accepted that the current wave of inflation is the result of supply chain disruptions – exacerbated by war and sanctions – particularly of essential commodities such as food and fuel. If that is the case, long-term solutions require increasing inventories, including by removing bottlenecks.
Higher interest rates reduce aggregate demand. But simply raising interest rates won’t even solve the specific causes of inflation, let alone rising prices due to disruptions in the supply of essential goods, such as food and fuel.
Interest rate – arbitrary
Second, interest rates affect all sectors, everyone. It doesn’t even distinguish between sectors or industries that need to be expanded or encouraged, and sectors or industries that need to be phased out because they are less productive or inefficient.
Also, raising interest rates too often, and to extremely high levels, can pressure or even kill productive and efficient companies, along with inefficient or less productive companies.
Bankruptcies in the US had soared in the early 1980s after the legendary peak in Fed chairman Volcker’s interest rates. “Thousands of companies that have taken out bank loans could go bankrupt,” a leading UK tax consultancy recently warned.
Third, interest rates do not distinguish between households and businesses. Higher interest rates can discourage household spending, but also dampen all kinds of spending – both for consumption and investment.
Therefore, aggregate demand may contract, discouraging investment in new technology, facilities, equipment and skills. Higher interest rates thus have a negative effect on the long-term productive capacity and technological progress of economies.
Debt, recessions and financial crises
Fourth, higher interest rates increase the cost of debt service for governments, businesses and households. With the exceptionally low interest rates previously available after the 2008-09 global financial crisis (GFC), debt levels rose in most countries.
These undoubtedly stimulated risky, speculative behavior as well as unproductive share buybacks, higher dividends and M&A. Interest rate hikes have led to many recessions and financial crises. So raising interest rates is likely to lead to a new, albeit different, era of stagflation.
The pandemic has pushed national debt to historic new heights. Forty-four percent of low-income and least-developed countries were at high risk of, or were already in, an external debt crisis in 2020.
Before the COVID-19 crisis, half of the small island developing states surveyed already had solvency problems, i.e. they were at high risk or were already in debt. Raising interest rates could thus trigger a global debt crisis.
Fifth, paradoxically, higher interest rates increase the cost of servicing debt, especially mortgage payments, for indebted households. The cost of living also rises as companies pass higher interest costs on to consumers by raising prices.
Thus, the main beneficiaries of low inflation and higher interest rates are the holders of financial assets who fear relative depreciation.
Developing countries vulnerable
Developing countries are especially vulnerable. Higher interest rates in developed countries – especially the US – lead to capital outflows from developing countries – leading to price falls and inflationary pressures.
Higher interest rates and weaker exchange rates will exacerbate the already high debt burden – as happened in Latin America in the early 1980s after US Fed Chairman Volcker sharply hiked US interest rates.
Developing countries are raising interest rates sharply to discourage sudden capital outflows and avoid major currency depreciations. This could lead to economic collapse – as in Indonesia during the Asian financial crisis of 1997-1998.
While pandemic response measures – such as debt moratoriums – provided some relief, insolvencies increased by nearly 60% in 2020 from 2019. Middle and low-income countries saw more bankruptcies.
The World Bank’s Pulse Enterprise Survey — of 24 middle- and low-income countries — found that 40% of companies surveyed in January 2021 were expected to be in arrears within six months.
This included more than 70% of the companies in Nepal and the Philippines, and more than 60% in Turkey and South Africa. Business failures of this magnitude can trigger banking crises as non-performing loans suddenly skyrocket.
Rather than rein in current inflation, raising interest rates is likely to seriously harm the recovery and medium-term growth prospects. Therefore, it is imperative for developing countries to innovatively develop appropriate means to better address the economic dilemmas they face.
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© Inter Press Service (2022) — All rights reservedOriginal source: Inter Press Service