Are interest rate hikes the right policy?

As traders are on edge anticipating a 75 basis point hike in interest rates from the Fed, it is important to take a good hard look at the implication of this policy. Last week we saw Central Banks around the world tighten monetary policy by raising interest rates. However, is this the best policy moving forward?

Understanding the effectiveness of raising interest rates requires us to understand what is currently driving inflation in the economy. It does not take a Masters’s degree in Economics to understand that inflation is being driven by supply-side issues. Here are some of the main factors driving high prices worldwide:

1. Supply chain bottlenecks that are caused by COVID restrictions. China’s strong stance on a zero COVID policy is still causing bottlenecks in the shipping industry. The world has not yet recovered from the supply chain bottlenecks caused by COVID restrictions. As COVID cases slow down worldwide, demand for consumption is going up faster than the supply chain can adapt.
2. Labor shortages were a key characteristic of the pandemic. We saw an unprecedented drop in employment rates worldwide as people were faced with the threat of a deadly virus. Health concerns coupled with government restrictions led to a labor market shortage. In my opinion, this trend has been further exacerbated by generous stimulus payments made by governments worldwide.

By March 11, 2021, the Biden administration had already dolled out $90 million in stimulus checks according to a CNBC report by Lorie Konish.

3. Rising oil price caused by the Russia-Ukraine war is also driving inflation worldwide. As the price of oil rises it further fuels the rise in the cost of final goods and services. With no diplomatic resolution in sight, the lack of export of oil from Russia is likely to continue driving prices upwards.

All of these causes of inflation suggest that inflation is mostly cost-push as opposed to demand-driven. Yes, the demand for goods is higher compared to the peak pandemic times, however, these are not the biggest drivers of inflation in my opinion.

So we have what is primarily cost-push inflation. This type of cost-push inflation from supply side issues poses a serious dilemma for central banks. On the one hand, they can raise interest rates to tackle the gap between total demand and actual supply, however, doing so can cause a drop in output leading to a recession. But what does this mean for the general public? Here’s what a rise in interest rate can mean for you:

1. Rising mortgage payments for homeowners. As interest rates go up this will put pressure on households as they have to make higher mortgage payments on their home loans.
2. Rising interest costs for businesses. Businesses with loans could see a further rise in their costs as required interest payments go up. Ironically, this will further increase supply side costs for businesses.
3. Lower demand from the economy for goods and services. A higher interest rate means taking on home or car loans will be more expensive and this will drive down consumption both at the household level and from firms looking to invest.

So in summary, a hike in the interest rate or an expectation of a hike can in fact lower consumer demand over time. However, consumer demand is not the primary factor driving inflation in our current economy. The Fed’s interest rate hikes would have been more effective if they came during the end of the pandemic. The communication of a potential hike could have prevented demand from rising to the pre-pandemic levels. A lack of such anticipatory communication inevitably leads to a loss in the credibility of the Federal Reserve.

So, what alternative policies can we take?

A hike in the interest rate at this junction is inevitable. However, focusing solely on this policy tool is not an optimum solution to the inflation problem. Authorities and institutions need to tackle the supply side problems at their roots. Investing in innovative solutions to solve the supply chain bottlenecks is a long-term solution to this problem.

A more short-term solution would be to aggressively seek a diplomatic resolution to the Russia-Ukraine war. The “Great Resignation” is also a major supply side problem that can be solved in the short run by designing fiscal policies that incentivize labor force participation and higher employment.

In short, I feel like institutions and state administrations around the world are not making the harder decisions by tackling the structural problems. Instead, they are focusing on alleviating the short-term woes of the economy.