After a period of extreme monetary easing that did not fuel inflation, as it was intended to, the balance has now tipped in the opposite direction. Policy rates are being raised extremely fast in response to an inflation shock, based on the argument that this should control sky-high inflation. The curious thing is that central bankers unblushingly continue to rely on models that in the past 15 years (if not longer) time and again misjudged the relationship between inflation and monetary policy. This ultimately causes more damage to our society than any good that it might do.
According to the models, higher interest rates should result in lower capital expenditure and less consumption. Because they make borrowing more expensive and saving money more attractive. With some delay, that should result in lower economic activity and higher unemployment. That is the route to lower inflation: less demand for products results in lower prices.
Anyway, that is the theory that central bankers have elevated to the status of a technocratic principle. In practice, the empirical basis for the relationship between unemployment and inflation is tenuous at best, let alone that monetary policy has any impact on this.
The previously unimaginable monetary experiment of negative interest rates and unconventional monetary policy that was carried out in recent years has consequently completely failed to get inflation up to the target of around 2%. Low and even negative interest rates did, however, have definite negative as well as positive effects on the economy. For instance, the abundance of liquidity was the main cause of house prices and share prices spiralling in the past 10 years. This in turn caused growing inequality between the haves and have-nots. And the problems in the financial sector were hidden by a blanket of liquidity. At the same time, governments were able to borrow cheaply and there was lots of cheap money available for start-ups. This meant ideal conditions for investment in areas such as the energy transition.
While the abundant liquidity has lifted the debt ratios of governments and the private sector to record levels, central banks now have no qualms about using the same arguments that have proved invalid for years to raise interest rates at a record rate.
And, again, monetary policy proves unable to make an impact in the area that is its primary focus. Since the start of the interest rate hikes, the world economy has only performed better than expected, while the higher interest rates have hardly moved the needle for (core) inflation. So for me there is really only one conclusion: interest rates do not work like we have envisaged in the models. Monetary policy has an impact on the economy mainly via the balance sheets of companies, governments and households. And it takes more time for that impact to materialise. It is not until consumers start refinancing mortgages, corporate loans need to be renewed or more borrowing is needed that the economic impact becomes apparent. And given the high debt levels, the impact of that monetary policy on the real economy could well prove very painful. In several countries, those debts already start causing payment problems due to the sharply higher interest rates. Because it does not take long for debt reduction to expose the weak areas in the financial system.
Placing the burden on the financial system would really lead to a reduction of debt levels, but central bankers are clearly shying away from that. That is why they are calling on the labour unions to moderate their wage demands to avoid the dreaded wage-price spiral. That not only bears testimony to their own incompetence in terms of setting monetary policy, but also means they are getting involved in politics. But most of all: they have got the wrong end of the stick. What we are dealing with here is a price-wage spiral. Inflation was set off by external price shocks, ranging from disrupted trade chains during the pandemic to energy and commodity price rises due to the war in Ukraine. Certainly not by irresponsible wage rises and high wage costs.
And the latter may well be the biggest problem posed by the current monetary policy: it has, without any legitimate basis, been politically disguised as an economic model. Assumptions and values captured in equations. This monetary policy is making itself felt in three areas.
First, interest rate policies cause distribution effects. Interest rates can be considered the reward for a loan, i.e. return on capital. Likewise, wages can be considered the return on labour. So when interest rates are raised (considerably), the return on capital rises versus the return on labour. If central bankers then call for moderation with regard to wage rises, they interfere with the balance of power between employers and employees. This is problematic especially in times of proven ‘greedflation’, which causes high profits.
Second, Joe Public ends up footing most of the bill. Because when higher interest rates start to affect the financial sector, and therefore start causing pressure on debts, central banks immediately come to the rescue under the guise of safeguarding financial stability. Just take Silicon Valley Bank and other banks in the United States: they could not be allowed to fail and were therefore rescued via the central bank’s balance sheet. In this system, with these mandates, the only way in which central banks can achieve price stability is by making ordinary people bear the burden. In central bank speak this is called the sacrifice ratio.
Third, the rapid rise in interest rates has raised the return requirement for many projects that are essential and useful for environmental and social reasons, including the energy transition, nature recovery and education. These types of projects, for instance renewable energy projects, are particularly sensitive to this. This will certainly make funding with private money more difficult, but the same is also true for public funding.
It would be great if these political dimensions of monetary policy were also considered during the public debate. Money is too important to leave it to central bankers to call all the shots.
This is a translation of Hans Stegeman's column in Dutch newspaper NRC, published 15 May 2023.
