The big question is: Are higher rates actually making inflationary pressures worse? Will this blunt instrument succeed under current circumstances?
Contrary to expectations that rates would stay low for another two or three years, central banks are suddenly pursuing aggressive hikes. These hikes follow failure to forecast post lockdown price rises. Rate hikes may prove to be too little, too late. Bankers may discover that current economic woes are appearing against a backdrop of more nuanced problems.
As a saver, I obviously welcome better returns and also welcome any policies that halt inflation. However, I do fear that central banks may find that tightening monetary policy may not be as effective in achieving their objectives this time around.
Instead, their actions could trigger economic instability, even higher inflation with more rate hikes to come. This economic time bomb coincides with a rush towards the great 'green' energy transition which will doubtlessly be extremely expensive for us all. Far from helping the poorest in society, the move to 'green' will compound inequality, reduce living standards and frustrate ordinary people’s aspirations. It's a case of economics vs ideology.
In normal circumstances rate hikes are designed to suppress demand by capping discretionary spending. Working families, the middle classes and their pay packets are often seen as sacrificial lambs when it comes to battling inflation. But that doesn't often end well because it creates industrial unrest, social disquietude, strikes and protests.
My fear is that rate hikes won't address supply factors such as the ones ongoing after Covid-19. They're not equipped to do so. These supply-side issues will continue to persist as long as China continues its aggressive zero approach to Covid-19. Then, we have to contend with geopolitical events, resource scarcity as well as climate change. Rate hikes won't remove sanctions on Russia either. They're already having a massive effect on food and energy supply and costs. It's arguable just who these sanctions are hurting the most.
Perversely, high interest rates can actually feed inflation. Basically, it represents just another additional cost burden. Many businesses were forced to borrow more during the pandemic, citing low borrowing costs as justification. But as repayments now cost much more, as usual, business will have no other recourse except to pass on increased expenses to consumers. All this as well as increased mortgage payments add to higher wage demands. It's a vicious inflationary circle.
Rate fluctuations can affect currencies too. Devaluation of local currencies increases the cost of importing goods including fuel to those territories. During the 80s and early 90s a combination of recessions, high inflation and very high interest rates badly impacted manufacturing and drove a lot of it abroad. Particularly towards low wage Asian economies where much of it has remained. Whilst exporting manufacturing has absolved much of the West of its emissions responsibilities, it also created last minute supply chain structures which are now massively compromised.
I believe that central banks are still languishing in the belief that high interest rates burst the 1980s inflation bubble. What might not be so widely recalled are all the other measures that played an equally key role, such as deregulation which weakened the power of trade unions. Far away India, China, eastern Europe and Russia were brought into an increasingly globalised trading system providing cheap labour and abundant low cost commodities. All this served to lower the cost of Western goods and services. The result was three whole decades of gloriously low inflation. Party time!
But what we've done is massively enrich these countries, especially China. As a result China has created a huge middle class consumerist society all of its own. China is now actively competing for the very resources and commodities that they were once happy to sell us. The tides have turned. They wanted what we'd got and they got it in a frighteningly short timescale!
Closer to home, central banks have contributed to the inflationary spiral. Initially banks cut interest rates in order to protect depositors. They had to prevent the wholesale collapse of the financial system back in 2008. Since then, central banks have shown a persistent unwillingness to bring rates back up to normal levels. They therefore helped stoke an inflationary tsunami. Abnormally low interest rates over a prolonged period dramatically pushed up house prices and even fuelled a property boom. Considering that housing plays such a key role in how inflation is measured, it's astonishing that inflation hasn't shown up much earlier than it has.
Add to this rancid witch's brew the rather complex role of quantitative easing. Central banks effectively financed governments by buying up debt. This money was often wasted leading to record global debt levels with some governments, already myred in impossible financial quagmires. Alarmingly, some may not be equipped to withstand higher interest expenses. The European Central Bank has been struggling to try and contain the effect of rising rates on highly exposed member states such as Italy.
There are clearly increasing threats to household finances. Positivity in the price of assets, including shares, pensions and property relied on the assumption that low interest rates would persist. While actual interest rates remain very low in historical terms, the recent rises have led to stocks falling by up to 20%. A rise from 0.25% to 0.50% actually equates to a 50% hike whereas a hypothetical rise from 10% to 11% is only a 10% increase in real terms despite it being a whole percentage point rise opposed to fractions. This also means that property values are also under pressure. Even Crypto currencies have sustained eye watering losses.
Low interest rates have lubricated investment channels into developing countries. But now rising rates, higher energy and soaring food prices are proving to be a problematic environment for emerging markets which have been important trading partners for the West. Interest rate rises were a key factor behind historical financial crises both in Asia and Latin America. It looks like boom and bust cycles continue to haunt our prospects globally.
Governments and the central banks will doubtlessly one day proclaim their triumphs against the spectre of inflation. Statistics are often micromanaged. However, in reality, if the cost of a loaf of bread increases from €1 to €1.20, it equates to a 20% rise. If, however, the price remains at €1.20 the next time it's measured then the price inflation is zero. Brilliant news! Meanwhile, back at the ranch, the actual cost of living will not have decreased one iota because the bread will still cost €1.20.
So. Interest rate hikes may yet eventually produce an economic slowdown. In turn, this will impact already decelerating economic activity and even harm employment prospects in the longer term. As with most intervention, the laws of unintended consequences might kick in thereby sparking off turbulence on the financial markets (already happening to some degree). Central bankers will eventually be forced to backpedal and possibly once again slash interest rates and pump yet more money into the economy therefore revisiting the same old territory.