Decrypted: Why Central Banks Raise Interest Rates to control Inflation& Ensure Economic Stability
Ira Singh
8 Aug’23
Stable prices are a crucial prerequisite for sustained economic growth. With risks to the inflation outlook tilted to the upside, central banks must continue normalizing to prevent inflationary pressures from becoming entrenched. They need to act resolutely to bring inflation back to their target, avoiding a de-anchoring of inflation expectations that would damage credibility built over the past decades.
The US Federal Reserve’s relentless and aggressive rate rises over recent months to curb inflation have battered the rupee, and most other emerging and developed market currencies.
“Clearly, the fast-evolving world order and consistent repricing of Fed’s out-sized hikes are strong-arming the emerging markets,” said Madhavi Arora, lead economist at Emkay Global Financial Services.
Policymakers around the world are grappling with a sweeping shift away from their respective currencies and into the safe-haven dollar, raising worries of capital outflows and further damage to their economies.
Economists have said the RBI, too, would need to focus on ensuring the interest rate differential is not too low.
With inflation at multi-decade highs in many countries and pressures broadening beyond food and energy prices, policymakers have pivoted toward tighter policy. As Chart of the Week shows, central banks in many emerging markets proactively started to hike rates in recent year, followed by their counterparts in advanced economies in the final months of 2021.
Black swan’ events and inflation
When author Nassim Nicholas Taleb coined the term ‘Black Swan’ in his book of the same name, he may not have imagined the enormous impact of the word on the global economy. A ‘black swan’ event is an unexpected and random incident which has a long-lasting impact on the economy.
The Covid-induced global lockdowns and the ongoing Ukraine war are clearly ‘black swan’ events. The twin events, which hit the world within a gap of two years, continue to disrupt the global supply chains and commodities markets, leading to a slowdown in the global economy and massive inflation worldwide.
Global inflation continues to be above the pre-pandemic (2017-19) levels of 3.5 per cent. According to the International Monetary Fund’s forecast, the global headline inflation this includes prices of food and energy stood at 8.7 per cent last year. It fell to 6.8 per cent in 2023 and is expected to further decline to 5.2 per cent in 2024.
The inflation monster has eaten into the pockets of people living in advanced as well as poorer countries. To put inflation numbers in perspective.
Major central banks across the world have been raising their interest rates aggressively to combat surging inflation. In 21st Century economics, this is commonly called the ‘Taylor rule’. Named after the US new-Keynesian economist John B Taylor, the rule entails a higher interest rate when the inflation rate is higher and vice versa.
The conventional argument is that a high interest rate makes it costlier for people to borrow money. With borrowing getting expensive, consumers are forced to spend less. When spending declines, there is a fall in demand. It is therefore postulated that weakening demand will eventually reduce the price of goods.
This is precisely the logic behind global central banks rising the interest rates, when the inflation rate is not in the target range. Inflation targetting is a major monetary policy tool used by central banks to keep inflation within a tolerable range. This tolerance band varies from country to country. In the US, the inflation target is at 2 per cent. In India, the target is 4 per cent, with 2 per cent being the lower range and six per cent being the upper limit, according to information.
The conventional monetary strategy has helped countries bring down inflation, though not to the levels they believe are ideal.
High interest rates however have an unintended negative pull on the economy. The ongoing economic downturn around the world is an example of central banks prioritising lower inflation over healthy economic growth.
The conventional monetary strategy has helped countries bring down inflation, though not to the levels they believe are ideal.But eventually, no country can truly come out of economic misery by just adjusting the monetary policy. That would mean prolonged stress on the growth prospects of a country.
Higher interest rates lead to a domino effect, with severe long-term consequences for economic growth. Higher interest rates lead to a fall in consumer demand as people have less income to spend. This in turn impacts industrial output as lower demand means less production. Eventually, lower industrial performance forces companies to lay off employees, leading to a rise in unemployment.
The ongoing global economic downturn encapsulates the domino effect pretty well. Many now argue that the looming fear of recession in several advanced countries is a result of central banks continuing with unabated rate hikes.
Currently, central bankers face a two-fold challenge. They need to deliver on economic growth to avoid a recession and also tame high inflation. It will be a tough balancing act. In monetary policy, that’s called ‘soft landing’ – a situation where central banks will raise rates enough to fight inflation but without causing a severe economic downturn.