The point of an 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.
LAST WEEK, the US central bank, often called the Fed, announced that it would raise interest rates by 75 basis points (or 0.75 percentage points). The Fed is doing this to bring down inflation to its target rate of 2% At present, inflation in the US is closer to 9%. Most observers have noted that 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%, the US will go into a recession. Interest rate hikes
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?
Apart from making things costly, it essentially erodes the basis on which one makes economic decisions. Should one buy a car today or six months later? Should one lend money? Should one hold back on repaying old loans? Will one’s income be enough to pay the bills in six months’ time? Should one invest in starting a new business? And so on.
And what is recession?
The technical definition of a recession requires an economy to contract for two consecutive quarters; a quarter is a period of three months.#Interest rate hikes
What is causing inflation?
Both the Feb 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.
For instance, during the June monetary policy review, while sharply revising the inflation forecast for the current financial year to 6.7% from an April prediction of just 4.5%, RBI Governor Shaktikanta Das said: “75 percent of the increase in our inflation projection, compared to what we had made in April, is attributed to food inflation… primarily the food inflation spike is liked to external factors, namely, the war in Europe.” ##Interest rate hikes
US Fed Chair Jerome Powell, too, gave the same reason.
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 bluntly asked him whether the US Feb 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. In its June Bulletin, it states: “There is no doubt that the first impact of a food and fuel price shock to inflation lies outside the realm and remit of the RBI – especially with food and fuel prices constituting 60 percent of the CPI and the food shock emanating from external sources, in this case, the war in Europe.”
Then why are central banks raising interest rates?
The answer lies in what are called “inflation expectations”. Simply put, inflation ex-pectations 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.
For instance, what would you do if you expected that the car you want to buy today will cost almost 20% more next year? Expecially so, when you expect your income to go up by just 10% in the meantime? Chances are you will buy the car today when inflation has not yet eroded your purchasing power. Interest rate hikes
Similarly, if you expect the general price level to rise by 10% over the coming year, you might ask your boss for a raise of 15%. That’s because a 10% raise will, in your view, barely cover you for the higher prices that you will have to pay. To get a “real” increment of 5%, you need a nominal increment of 15%. Interest rate hikes
Alternatively, imagine a scenario when your think prices will actually go down in the coming year (this phenomenon is called deflation). In such a case, you might postpone buying that car; hoping to buy it for less next year.
The net effect of these individual decisions to advance or postpone purchases or ask for higher wages etc. determine the course of a country’s economy.
The crucial point here is to understand that people’s expectations of inflation often determine what the future inflation will be. For example, if people expect higher inflation and advance their purchases, there will suddenly be a spike in demand, far in excess of the supply, thus causing higher inflation.
As such, policymakers try to gauge what is happening to inflation expectations. Gauging these is neither easy nor straightforward, and central banks conduct surveys to assess what is happening to inflation expectations.#bestndacoachinginlucknow
So, how does raising the interest rate contain inflation expectations?
Inflation expectations tend to be “backward looking”.
“(Households) tend to look at recent food and fuel prices which are salient items in the average consumption basket and they form their opinion about what inflation would be in the future, say three months or a year from now. If households believe that inflation will go up and stay up, they are in effect saying that it is better to prepare for that difficult situation,” the RBI’s June Bulletin says.
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. For instance, dismayed by higher interest rates, many may postpone buying a new car, thus reducing the demand for fuel. Interest rate hikes
By disincentivising 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.
In short, ensuring inflation expectations stay “anchored” is the essential goal for monetary policy. Reducing inflation is a way to achieve that goal and raising interest rates is a way to achieve lower inflation. Interest rate hikes
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.