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Will interest rate increases bring inflation under control?

Published by: Lucien Paulemil
April 14, 2022 6:59 am

Indeed, inflation is hitting record levels on every continent: In the USA, prices rose 7.9% over the last 12 months, Eurozone annual inflation hit 7.5% in March 2022, India’s inflation accelerated to 6% in January, and Latin America’s inflation broke the 10% mark in 2021.

The coronavirus pandemic and the war in Ukraine have unleashed severe monetary and economic instability on the world markets.

Clearly, rising prices are one of the most pressing issues facing politicians and central banks in 2022. The question is: will the central banks increase rates given the challenging economic context?

Why rate increases are needed?

Interest rates are arguably the most important monetary tool in policymakers’ arsenal. The rate set by central banks determines the price of short-term lending: the lower rate, the cheaper credit is for individuals and businesses.

The danger of low rates it that it fosters monetary expansion. If too much money injected in the economy, prices increase to capture the excess liquidity. This is the situation we are in today: quantitative easing combined with covid-related supply chain disruptions result in record inflation rates.

Thus, it is evident that central banks need to raise rates to contain inflation. Indeed, most central banks’ mandates clearly state that their mission is to keep inflation under 2% - and they are well off the mark. Increasing rates is arguably the only conceivable way to bring inflation under control.

Why interest rates can’t be raised

It is easy to say that rates should be increased quickly to lower inflation.

However, things aren’t so cut and dry.

An increase in interest rates means that credit becomes more expensive. As a result, individuals and businesses must pay higher interest rates to borrow money. This means that mortgages become more expensive, and families must either delay or cancel home-buying plans. In parallel, businesses must scale back their investments or downsize to fund capital expense projects. Often, this results in lower economic growth.

The danger is that if the economy is not ready to absorb a rise in the cost of credit, a rapid increase in interest rates may cause a recession. Thus, central banks must proceed with caution.

Will central bank increase interest rates?

At the end of 2021, central banks were adopting hawkish tones to prepare the markets for several rate increases over the next two-three years. However, Russia’s invasion of Ukraine has disrupted their plans.

Indeed, the Ukraine crisis has sent energy prices soaring, which means that inflation will rise even more for the foreseeable future. Consequently, individuals have less purchasing power to allocate to discretionary expenses, which will have profound impacts on corporate profitability.

For example, BlackRock analysts believe the Eurozone will suffer high inflation and low economic growth over the next few years. Raising interest rates too quickly could create stagflation – a situation where inflation is high, and growth is low. This is bad for all parties.

In any case, while both the Federal Reserve and the European Central bank appear committed to raising rates at a slow albeit regular pace, BlackRock concludes that the banks will resist steep increases and blame the rising inflation on Russia.

\Will this be enough to contain popular unrest?

Only time will tell.

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