How Raising Interest Rates Tackles Inflation: A Critical Analysis
Inflation control through the implementation of rising interest rates is a critical aspect of monetary policy, aiming to balance economic growth and stability. This article delves into the mechanisms and consequences of this strategy, providing a comprehensive understanding of the economic implications.
Controlling Inflation
Raising interest rates is a widely used mechanism to combat inflation. It primarily works by reducing spending and borrowing, thereby slowing down economic activity. When interest rates rise, the cost of borrowing increases, compelling consumers and businesses to defer large purchases like housing or significant investments. This reduction in demand helps to alleviate upward pressure on prices, thus controlling inflation.
For example, for larger ticket items such as real estate, a small decrease in interest rates can significantly impact the cost of purchasing a home. A one-point drop in interest rates on a $300,000 mortgage can save hundreds of dollars in monthly payments. Therefore, the decision to make large purchases needs to be deferred until interest rates are more favorable.
A Critique of the Fed's Actions
The recent actions of the Federal Reserve (Fed) in raising interest rates without a corresponding decline in inflation rates raise questions about the efficacy of monetary policy. Last month, despite no change in the inflation rate, the Fed raised interest rates. This move appears to be a strategic attempt to collect more money from the populace rather than addressing inflationary pressures. This approach may seem illogical at first glance, yet it is becoming increasingly evident that such measures are aimed at extractive purposes.
Consequences of Higher Interest Rates
Higher interest rates result in several economic changes:
Reduction in Consumption and Investment
As the cost of borrowing rises, consumption and investment typically decrease. This is because it becomes more expensive to finance large purchases or new projects. Consumers might delay big-ticket purchases, and businesses may be deterred from expanding or investing. Additionally, the increased interest rates can lead to an increase in saving, as people feel more secure holding onto their money due to the higher interest rates.
These actions will have an impact on the financial inflows from foreign savers, who prefer to deposit their money in local banks with higher interest rates. However, this can also lead to an appreciation of the domestic currency, reducing international competitiveness and potentially lowering the demand for exports.
Impact on International Trade
Higher interest rates can impact the trade balance of a country. Due to the appreciation of the domestic currency, exports become more expensive for foreign buyers, while imports become cheaper. This can lead to a reduction in net exports, further dampening demand-pull and cost-push inflation.
Theoretical and Practical Implications
Theoretically, raising interest rates should incentivize individuals to save more and defer consumption. However, in practice, the effectiveness of this strategy can be limited. For instance, in the UK, Barclays Bank offers only 0.54% interest on savings, which is substantially lower than the Bank of England's base rate. Despite multiple rate hikes by the Bank of England, these savings rates remain stagnant, effectively torpedoing the savings channel. This disconnect between the central bank's monetary policy and commercial banks' practices has led to inflation rates exceeding 10%, highlighting the failure of conventional measures.
Additionally, increased mortgage rates and commercial loan rates further deter borrowing, leading to lower house prices and reduced business investments. However, this strategy seems to have limited impact on goods inflation, such as food prices, which are driven by supply and demand factors. Furthermore, corporate pricing power, bolstered by the expectation of inflation, makes it difficult to curb price rises.
The Central Bank's Role
The inaction of the Central Bank in addressing these issues highlights a significant gap in the implementation of monetary policy. The real interest rate on savings in the UK is a negative 9.86% (approximately 0.54% savings rate minus 10.4% inflation rate), indicating that people are effectively losing money when they save. This situation undermines the effectiveness of monetary policy and exposes the fragility of the current economic framework.
The persistent high inflation, coupled with feeble central bank oversight and the misalignment of commercial banks' practices, suggests that the economic climate is likely to remain volatile. Without decisive action, the UK is likely to see its inflation rates persist and perhaps even exacerbate, making the populace poorer in the process.
In conclusion, while raising interest rates is an important tool for curbing inflation, its effectiveness is contingent on the alignment of various economic factors. The disconnect between the central bank's policies and the practices of commercial banks highlights the need for a more cohesive and comprehensive approach to monetary policy.