The Point of Interest rate hike

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The Point of Interest rate hike

  • Interest rate hikes by central banks, such as RBI, will not bring down food or fuel prices. But they will suppress credit-led demand, and in turn inflation. The goal is to keep inflation expectations anchored.

When the U.S. sneezes, the world catches a cold

  • Every time the Fed has tried to reduce inflation even by as little as 2 or 3 percentage points, it has led to a recession.
  • In other words, if the Fed remains steadfast in its resolve to bring down inflation to 2% from current close to 9%, the US will go into a recession.
  • A similar trend is unfolding across the world including India, where the RBI has been raising interest rates in a bid to contain inflation.
  • In India, instead of a recession, the damage may be limited to a reduction in GDP growth.

What is inflation? How does it affect you?

  • Inflation is the rate at which prices rise. A 2% inflation implies the general price level in April this year was 2% more than what it was in April last year.
  • A "rising" inflation rate implies that the rate at which the prices rise itself is increasing.
  • Take India, for example, where the inflation rate steadily went up from close to 4% in September last year to almost 8% in April this year.

Why is inflation bad?

  • It makes things costly.
  • It essentially erodes the basis on which one makes economic decisions.

And what is recession?

  • The technical definition of a recession requires an economy to contract for two consecutive quarters.

What is causing inflation?

  • Both the Fed and the RBI have stated that the current inflationary spike is due to supply constraints - in particular, due to rising costs of food and fuel.

But how will raising the interest rate reduce food or fuel prices?

  • It won't, and the central bankers know they cannot bring down food and fuel prices by forcing banks to charge a higher interest rate from people wanting to buy a new car or opening a new shop or even taking an education or home loan.
  • When a journalist asked whether the US Fed was trying to induce a recession to bring down inflation.
  • Powell admitted his helplessness in bringing down inflation because of "factors that are not under our control".
  • The RBI too expressed the same helplessness.
  • Especially with food and fuel prices constituting 60 per cent of the CPI.

Then why are central banks raising interest rates?

  • The answer lies in what are called "inflation expectations". Simply put, inflation expectations refer to people's (or households') expectations of what the inflation rate will be in the future. And they matter because these expectations are what determine people's economic behaviour.
  • The net effect of individual decisions to advance or postpone purchases or ask for higher wages etc, determine the course of a country's economy.

So, how does raising the interest rate contain inflation expectations?

  • Inflation expectations tend to be "backward looking".
  • When a central bank raises the interest rate, while it may not be able to increase the supply of food and fuel, it does dampen the demand for these goods.
  • By disincentivizing borrowing (because it is now costlier) a central bank reduces borrowing-led demand. This does two things.
  • One, it reduces inflation by bringing down demand, and
  • Two, it gives time for the supply to catch up with the demand.

Way forward

  • Ensuring inflation expectations stay"anchored" is the essential goal of monetary policy. Reducing inflation is a way to achieve that goal and raising interest rates is a way to achieve lower inflation.
  • But as central banks try to achieve this goal, expect more interest rate hikes in the coming months, which in turn, will dampen economic activity all around.