Raising interest rates to curb inflation is counter growth

By The Standard and Newsday | Feb. 28, 2022 | 4 Min read

They are lessons to be drawn from the post-Spanish flu pandemic which was marked by the economic recession of 1920-21 characterised by extreme deflation before an economic and baby boom.

By Tapiwa Gomo

SOMETIME in June 2020 at the height of the COVID-19 pandemic, the World Bank warned that the rapid and massive shock of the coronavirus pandemic and shutdown measures to contain it would plunge the global economy into severe shrinkage. And this was expected to result in a massive global recession, probably the worst after the Second World War.

The reasons for the warning were simple. They are lessons to be drawn from the post-Spanish flu pandemic which was marked by the economic recession of 1920-21 characterised by extreme deflation before an economic and baby boom. The reaction to these lessons is that if countries can avoid an economic recession, then they can easily bounce back and faster.

Another reason is that during the current COVID-19 pandemic, economic activity shrank as domestic demand and supply, trade and finance were either severely disrupted or shutdown. These have left many sectors of the economy severely battered. The COVID-19 pandemic is still here with us but there is evidence that its threat is slowly abating and with vaccination scaled up, most measures to contain its spread have been relaxed. This has seen most economies cautiously opening up.

But there is a widespread fear that a massive inflation is upon us and is about to hit global and emerging economies. The response has been a generalised increase in interest rates as part of containing it. Since mid-2021, most of the big and emerging economies such as the United States of America, United Kingdom, India, Indonesia, South Africa, Russia, Brazil, Mexico and others started raising their interest rates to firewall their economies from the anticipated global inflation.

Is this generally the right direction to take and what is the relationship between interest rates and inflation?

There is an underlying assumption that raising or lowering interest rates in an economy will either boost savings or spending. Increasing interest rates is thought to increase the cost of borrowing for commercial banks which encourages them to increase their own interest rates, which is ultimately expected to yield higher returns for saving consumers.

But it is the opposite for the borrower. Higher cost of borrowing diminishes demand and economic activity.

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Technically prices of goods and services increase and some global economies such as the USA are already witnessing price hikes as high as 40%.

Consumers are discouraged from spending by high prices, thus slowing down growth.

For example, if an asset loan becomes more expensive, consumers may decide to hold on to their cash in their savings account. If more cash is held in bank accounts and less is spent for fear of losing value due to inflation, money supply will reduce thus curtailing demand for goods and services. In addition, business may also decide to defer expansion plans and delay hiring additional employees. That is the downside of increasing interest rates even though the economic dashboard will look balanced.

Of course there is some political merit for central banks in that reduced demand slows down inflation. Interest rate hikes have an effect on prices of goods and services. And if prices go up, demand reduces throughout the economy. This is thought to reduce or slow down inflation. How? If the price of an asset goes up because of increased interest rates, its demand is expected to drop. In order for the seller to sell the asset, they are forced to either wait for the customer who can afford or to reduce the price of the asset. This means the seller has to face reduced profit margins or reduced sales to stay in business. Business — the engine of the economy — suffers but from a central bank perspective, this will be seen as an effective way of addressing inflation.

On the other hand reducing interest rates, drops the cost of borrowing for banks which encourages them to lower their own interest rates thus reducing interest on both savings accounts and loans. Technically borrowing and spending are more attractive to economic growth than saving as they stimulate money supply, induce high spending on goods and services.

Are these measures really necessary? It is a tough question to answer given that currently it is just an inflation paranoia — pure speculation as none has happened. Sadly consumers in countries that have already increased rates are paying for this speculation with prices of essential commodities already up. And even if inflation happens, it can easily be managed without causing unnecessary disruption to economies.

Some economists have cautioned governments over a generalised all-size-fit-all approach to firewalling their economies against what appears to be a looming global inflation by raising interest rates. They have warned that a blanket approach may stifle growth mainly for those economies emerging from the impact of the COVID-19 pandemic. These measures may have major and wider effects pushing millions more people into unemployment and destitution on a phenomenon that can easily be tamed without major economic adjustments.