Rate rises won’t work – time for some new tools
Economics is sometimes referred to as the dismal science, but economist Shamubeel Eaqub has a different view when it comes to some tools of his trade: ‘‘There is no science, it’s all made up, right? I mean, it’s whatever works at the time, and it keeps changing.’’
He is talking about the traditional role of central banks in keeping inflation low by raising interest rates. It is a hot topic now, because we are facing steep increases to combat rising inflation.
Traditionally we have seen inflation and interest rates as intrinsically linked: lower interest rates mean more borrowing, higher demand and therefore higher inflation. But the current situation calls into question how useful inflationtargeting tools are.
After the global financial crisis, central banks started cutting interest rates, sometimes into negative territory, to reinflate their economies. But banks ended up lending more money for financial assets and property than to riskier – and potentially more econmically beneficial to the economy – investments such as businesses.
Falling home ownership rates also meant interest rate cuts did not create the same spending kick they once did. Asset inflation took off, but in the real economy prices and wages stayed pretty much where they were (if they didn’t fall).
That was then. Now we face the prospect of real inflation. The interest rate hikes of 2021 and 2022 are supposed to head off this storm at the pass.
Fisher Funds head of fixed interest David McLeish says the central bank’s tools aren’t suited for this either, because post-Covid we are dealing with a supply-side inflation shock, with constraints caused by backlogged container ships or a shortage of labour supply, rather than anything caused by the Reserve Bank.
‘‘So it’s already hurting us, this inflation, and then what the central bank then goes and says is your debt servicing cost is now higher as well, we’ll take more money out of your back pocket. That doesn’t fix the problem; that potentially makes it worse. It certainly makes the demand side of the economic equation worse.’’
Commodity prices are rising on the back of a lack of investment after years of low prices and divestment by large capital funds. To combat this price spike, the Reserve Bank might raise interest rates but, as strategy and risk consultant Raf Manji explains, this won’t necessarily achieve anything useful. ‘‘If petrol prices at the pump here go up, that impacts people on lower incomes because it eats up more of their disposable income. And then what? The Reserve Bank is supposed to hike interest rates and make them worse off?’’
Sometimes the best cure to high prices is high prices: if they continue to rise, firms may simply decide to cut back on expenditure without any need for an interest rate change.
Then there’s the other type of inflation many people would like the Reserve Bank to tackle: the inflation of houses prices and other assets. For an example of how tricky it might be to use interest rates to hold asset prices down, research out of the Federal Reserve Bank of San Francisco looked at the 2008 housing bubble and financial crisis, and whether early interest rate hikes might have prevented it. The answer is yes, if interest rates had been raised by 8 percentage points in 2002.
It is not that the old prescription was wrong, but there seems to be a good argument that it has had its time.
Such a hike would have prevented the housing bubble, but it would also have caused the greatest contraction in economic activity since the Great Depression. In other words, raising interest rates to combat an asset bubble is not practical either.
As Eaqub sees it, the problem is that inflationtargeting has done its dash, and the Reserve Bank is using its main tool of interest rates to fight battles that tool was never really designed for. Over the next few years he thinks we will have to sort out why capital isn’t going to the places it needs to go, and how we can make sure it does.
Before the 1980s, the economy didn’t have enough capital. Now we have solved that problem, but we have another one in its place: that extra capital investment isn’t going anywhere useful.
There has been a glut of mortgage borrowing to fund a mass swap of second-hand houses, but there has been severe underinvestment in technology and other productivity-enhancing tools, not to mention infrastructure. Undoubtedly governments will be tasked with taking a more active interest in these problems, as they did after World War II in Germany and Japan, where capital was allocated to particular uses and industries.
Such intervention would fly in the face of what is politically acceptable today. It is not that the old prescription was wrong, but there seems to be a good argument that it has had its time.