Why are central banks hiking rates? An explanation of inflation

Mar 1, 2023 | General

Recent US inflation results were higher than expected and consumer spending was also higher than estimated. This is indicating the US economy is still strong and inflation not deceasing as hoped for. The expectation is for the US Federal Reserve to increase rates by 0.25% at their next three meetings and potentially a larger 0.5% increase next month.

Why are central banks hiking rates?

It is the key tool they have at their disposal to stimulate or dampen the economy.

High inflation rates cause issues in many areas. If inflation is higher than wage growth then workers will push for higher wages which raises costs for companies. This then leads to further increase in prices. The combination contributes to instability in the economy. As a result, central banks generally have a target for inflation (between 2% and 3% typically) which will provide sustainable economic growth.

An issue is that the inflation results or reports are lagging indicators. This means they show what has happened in hindsight. This means that the results of the current period are only known in the future. For example, the Australian Bureau of Statistics (ABS) releases consumer price index (CPI) results on a quarterly basis. The March quarter (January to March) is to be released on 26 April.

As a result, the Reserve Bank of Australia is basing their decisions on what has already happened.

Not what is happening.

There is a chance they hike rates too high and the full effect won’t be known until months/quarters down the track. Westpac’s chief economist, Bill Evans, stated on 24/2/2023 that he thought rates would end up being eased or reduced in the March quarter of 2024.

So, are there any other options than continuing to raise interest rates to reduce inflation?

Not so much for the central banks but governments can take action to try to achieve this outcome.

In a recent ABC article English economist John Maynard Keynes had ideas on how to control inflation at the start of World War II;

“You could eliminate peoples’ ability to spend too much (by raising taxes, or by lifting interest rates to transfer money from households to banks as a financial rent), or you could postpone their ability to spend too much (with mandated savings of some kind).”

Keynes said it would be much fairer to postpone peoples’ ability to spend because it would allow workers to keep the money they’d worked hard for.

Could something similar happen now?

Say a separate amount of money going to superannuation that people may have separate access to? A super plus account? For example, at times when inflation is high a percentage of pay goes to a super or a super like investment vehicle. It would take time to put the mechanisms in place and have legislation passed and maybe too much time to play a role in dampening inflation.

Australia’s top economists were surveyed in the middle of last year on how to tackle inflation and summarise that there are three kinds of action available to the government to bring inflation down and they are actions that:

  • Suppress consumer spending (“Demand”)
  • Boost supply of goods and services (“Supply”)
  • Directly restrain prices

The economists were divided on the best course of action and some thought no action apart from interest rate rises were needed.

It seems to me that mortgage holders are doing the bulk of the heavy lifting and if they represent around 30%-35% of the population the burden is not evenly shared.

For now I expect that the only course of cation will be further interest rate hikes over coming months and more pain for mortgage holders and especially those coming off fixed interest terms. Once inflation is under control it may be opportune to address other courses of action rather than just the interest rate lever for the next time inflation surges.

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