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              Interest rates and inflation – it’s time we stopped kidding ourselves

              There is little evidence supporting the idea that increasing interest rates brings down inflation. Focus should be on the supply side of the demand and supply model. Time to look at the needs of the citizens, not the market.

              Jim ByrnebyJim Byrne
              21-02-2023 11:51
              in Economics
              High interests more debt. Money squeezed

              Image by Steve Buissinne from Pixabay

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              “The standard tools for controlling inflation will do nothing to address the current sources of rising costs. These are rooted in global factors, from supply chain turmoil to continued upheaval as we learn to live with COVID-19.” Danisha Kazi Positive Money

              Does increasing interest rates help bring down inflation? Central banks across the world seem to think so. On the Bank of England (BoE) website you will find the following:,

              “…Higher interest rates make it more expensive for people to borrow money and encourage people to save. Overall, that means people will tend to spend less. If people spend less on goods and services overall, then the prices of those things tend to rise more slowly. Slower price rises mean a lower rate of inflation.” BoE

              In short, it’s the ‘too much money chasing too few goods’ story. However, on the BoE website, there are no links to research papers or statistics showing increased consumer spending. Why is that?

              Firstly, it isn’t clear that increasing interest rates brings down inflation

              There’s little empirical evidence that increasing interest rates brings down inflation. In fact, in a paper called, ‘Do Higher Interest Rates Raise or Lower Inflation?’ John H. Cochrane in 2016 states, “A review of the empirical evidence finds very weak support for the standard theoretical view that raising interest rates lowers inflation, and much of that evidence is coloured by the imposition of strong priors of that sign.” Increasing interest rates as a policy tool has many consequences, but whether reducing inflation is one of them, is up for debate. 

              This isn’t surprising given the number of factors at play and the difficulty of finding out which of those factors is the one ‘moving the needle’. 

              The orthodox theory is that raising interest rates means less spending on big purchases like new houses, cars and so on. The contraction in the economy – as businesses delay investment due to higher interest rates and lower spending – suppresses wage increases and leads to layoffs. Workers bargaining power weakens and wages are held in check. The resulting income and employment insecurity leads people to save rather than spend. The aim of higher interest rates is to have less money in the economy – available to chase goods – resulting in a reduction in prices.

              However, this ignores several countervailing factors. High interest rates also mean that government bonds/banks pay more in interest to investors/savers. Additionally, increased borrowing costs may be passed on to consumers as price increases. And as inflation hits people on lower incomes, they are forced to borrow to fund living expenses. Those bank loans increase the money supply, i.e., the opposite of the policy goal.

              If unemployment goes up – as predicted by the orthodox neoliberal economics model – it means that the government spends more to support unemployed workers.  

              So, raising interest rates leads to decreases and increases in the money supply. Depending on the balance between these factors, it could be argued that raising the cost of money is as likely to lead to prices going up as down. And in terms of an ‘overheating’ economy making money more expensive and increasing the money supply might lead to growth rather than contraction.

              Secondly, our current inflation isn’t caused by increases in consumer spending

              Current inflation has nothing to do with increased consumer spending. In fact, the little evidence available shows that consumers are spending less. So, if it’s not consumer spending, what is causing our current inflation? 

              Everyone and their granny knows that inflation has been caused by a combination of increased energy costs, Brexit and Covid related labour shortages, trade barriers, pandemic-related supply chain disruption, and the Ukraine war. These can all be characterised as, ‘supply–side shocks’. It is these supply-side shocks that have led to our skyrocketing energy and food prices.

              “…input cost inflation will remain a key headwind until at least the first half of 2023 (1H 2023). As such, prices will rise further in 2H 2022 as corporates seek to offset some of these costs,” September 14, 2022. Celine Pannuti, Head of Consumer Staples Equity Research at J.P. Morgan.

              Unless you are the BoE or the UK Government this is obvious. But the Tory Government sees inflation as a handy argument against pay increases, so they are happy to peddle the myth. And the BoE, has no other tools to use. It’s the equivalent of using a spanner for everything – including banging in nails and cleaning the windows – because a spanner is all you’ve got. As economist Neil Wilson put it, trying to control inflation using interest rates is the equivalent of trying to steer your car from the back seat by shifting your weight from one bum cheek to the other. It isn’t effective and the results are likely to be disastrous.

              top part of a british tax form.
              Economics

              Taxes don’t pay for services – so what are they for?

              byJim Byrne
              12 January 2023

              What can we do to bring down inflation?

              The supply and demand model still applies but it’s not the demand side of the equation we should be concentrating on, it’s the supply side. That being the case, what policies and solutions will impact the supply side? Here are a few:

              • Nationalise energy production. Leaving a critical national and economic resource in the hands of the private sector was, and is, foolhardy. The private sector is concerned with profit, not with national energy security. In the UK it was Thatcher’s privatisation mania in the 1980s that lies at the root of many of our current problems. And now that we have the climate emergency in the mix, it is well past time to reverse those mistakes.
              • Decrease reliance on fossil fuels by investing in renewable energy. This is an easy one so why is it happening in such a piecemeal way? Why did the UK Government decide to start cutting subsidies that support the uptake of renewable energy as far back as 2015? It is estimated that those cuts led to a loss of 2,000 jobs in Scotland’s wind farms since subsidies were cut.
              • Develop policies to combat labour supply shortages. Labour supply shortages mean disrupted supply chains, business closures, and staff shortages in health, agriculture, hospitality and more. One way to remedy this would be to reverse the UK’s hostile immigration laws, rejoin the EU and single market, provide free childcare, increase access to training and pay higher wages to attract workers. A one–time increase in wages is not inflationary as it is a one-time increase in costs, which also has the benefit of a multiplier effect on economic growth. 
              • Regulate prices and stop corporations from price gouging. Corporations are currently making historically high profits. Scots live in a country with an abundance of cheap renewable energy, yet they are paying historically high bills. In fact, Scots pay the highest energy bills in the world. This is obscene and an abuse of power by UK energy regulators – as energy policy is not devolved to Holyrood. It leads to greater inequality and increased poverty. Private firms – sanctioned by the UK Government – are currently breaking into people’s homes to install pre–paid meters. The likely result is that our poorest citizens will end up having their electricity cut off. Anyone who cannot afford to pay their heating bills needs support, not victimisation and profiteering by private energy firms. Those with pre-paid meters are being charged more than those without.
              • Grow the economy. If we agree that inflation can be caused by too much money chasing too few goods, then a logical solution is to produce more goods. More goods mean lower prices, i.e., we have the situation of too little money chasing too many goods – supply and demand does the rest. But increasing interest rates will not encourage growth. In fact, it is designed to do the opposite. Businesses will put off investment decisions, the risk/reward balance falls more on the risk side due to increased borrowing costs and having to fund expensive existing loans. Interest rate increases, we are told, lead to contraction, not expansion. Fewer goods are produced, growth plans are shelved, and workers are shed. If indeed inflation is being caused by too much expenditure chasing too few goods – hey presto – now you have even fewer goods. How does that help reduce inflation?

              Do something different – look at the needs of citizens – not markets

              In summary, there’s little evidence that increasing interest rates brings down inflation. Type the following phrase into Google, ‘research showing that increasing interest rates brings down inflation’. What you will find are lots of economists re–stating the logic but failing to back this theory up with evidence. Despite your precisely worded search phrase, you won’t find slews of research papers

              Raising interest rates is a regressive policy that increases the wealth of those with the most while increasing the poverty of those with the least. As prices and interest rates rise, lower-income families can’t just stop spending. So, they take on debt – which takes an increasing percentage of their income to pay back. Wealthy individuals, on the other hand, make money when interest rates are high plus the value of their savings goes up.

              “There is a risk that monetary policy may disproportionally benefit those in the higher ranks of the wealth distribution.” Isabel Schnabel – Member of the Executive Board of the European Central Bank

              It’s time we stopped kidding ourselves

              What we have are monetary policies based on neoliberal economic myths that don’t do what they are advertised to do. It’s time we stopped kidding ourselves that interest rate rises are the best way to bring down inflation. 

              We need policies based on evidence of how the economy works – rather than speculation on how it might work in an idealised theoretical model. And primarily we need a government with priorities based on the needs of citizens, not focused on financial indicators or erroneous belief in the ‘power of the market’ – to fix everything in the long run. We’ve had the long run, and orthodox neoliberal economic policies have given us increasing inequality, crippling poverty, and a planet–killing climate emergency. Higher interest rates won’t fix those issues any more than they are likely to bring down inflation.

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              Jim Byrne

              Jim Byrne

              Jim Byrne runs an award-winning web design and accessibility auditing business. Jim is also a musician and songwriter. With his wife Pat Byrne he runs Jim & Pat's Glasgow West End Chat podcast.

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