How policies can help to mitigate runaway inflation, and how they affect our economy
The rise in inflation between August and September was the sharpest since the Bank of England gained independence in 1997, calling for policies to control it. Interest rate policy can reduce inflation by suppressing aggregate demand and forward guidance does so by managing inflation expectations. The former can be manipulated quickly, but may become futile, while forward guidance can be an effective but risky policy tool. These policies have broader implications on economic growth and inequality due to their effects on aggregate demand and bank lending channels.
Interest rates are a great tool as they can be quickly and easily manipulated in response to changes in economic conditions. This allows the central bank flexibility and a rapid response mechanism to crises. However, there is often a time-lag with changes in interest rates, whereby they can take up to 18 months to have an effect, meaning that central banks do not have such control over changes in the price level as they wish. Additionally, it means that interest policy is a forecast into future, rather than current, inflation: this is no easy task.
To help with this task, central banks can use forward guidance to control inflation. Inflation expectations play a huge role in the price level: investors fearful of rising price levels are incentivised to invest now, which creates a reinforcing cycle of inflation. Forward guidance aims at control such irrational thoughts by setting thresholds and conditions that must be met for monetary policy to be changed. However, the central bank risks a loss of credibility if it falls to follow through with its promises. Currently, Andrew Bailey has warned that the Old Lady “will have to act,” which has spooked investors. This psychological effect may artificially tighten monetary conditions before such hikes begin, meaning the Bank of England no longer has to raise interest rates, which can limit the credibility of future forward guidance, making it futile.
These policies have significant effects on inequality. A fall in the interest rate reduces the yield on government bonds, which encourages investors to turn to equities for higher returns, which combines with lower borrowing costs to increase the demand for financial assets. Their prices then rise. Those in the top 1% of the wealth ladder the most, as the further up you go, the greater the proportion of wealth is held in financial assets. Rising house prices, also due to cheaper borrowing, benefits the next richest 9%, as most of their wealth is held in the value of their home. This leaves the rest of the field, who own very small portfolios, largely neglected, which increases the wealth differential. Unless, they are the beneficiaries of lower interest rates as they are able to keep their jobs. Reducing the cost for businesses and propping up demand can help firms to keep on their workers, rather than making them redundant due to profit squeezes. UK unemployment peaked at only 5.2% during the pandemic, despite major demand and supply disruptions. This can have longer-term effects on keeping people permanently employed, while lower the costs of rehiring workers following the recovery. However, these effects are not solely due to changes in interest rates. Extensive quantitative easing measures have artificially inflated asset prices too, while generous government support, such as the furlough scheme, has largely reduced unemployment. Hence, interest rate policy has benefited primarily the rich, leaving poorer households behind.
Interest rate policy also has effects on economic growth. Through different interest rate transmission mechanisms, such as the effects on borrowing and exchange rates, changes in the interest rate helps to dampen the economic cycle. This is desirable during booms, to curtail unsustainable growth, and during recessions to reignite demand. The UK economy is likely to return to pre-pandemic levels by 2022, which would not have been possible without such countercyclical policy options. However, demand in the current economic climate has shifted, not increased. Hence, a hike in interest rates may prove procyclical, by reducing demand at a time when high demand is not the issue, but high supply is. This is one of the weaknesses of the Taylor principle, used by central banks to base interest rates on, which combines inflation and economic growth to produce an appropriate nominal interest rate. However, if inflation and economic growth diverge, they cancel each other out and interest rates remain unchanged. This troubled the ECB during the 2011 oil price rise, and led them to raise interest rates, which proved to be an extremely unpopular decision. Hence, policies to control inflation have historically dealt with demand-side shocks but will struggle when crises are caused by demand’s partner in crime, supply. They are outdated and unfit for fthe future.
To conclude, interest rates offer versatility and flexibility, but come with frustratingly long lags which can make them hard to time well. Forward guidance is great at managing expectations, but promises must be followed through with, else credibility of the central bank diminishes. These policies are likely to widen inequality, particularly in the absent of populism to uplift poorer households. They are also outdated: future shocks from climate change and pandemics will be predominately supply-related, but such tools do not solve these issues. There must be reforms to central banks to give them the tools to fight such calamities, by allowing them to finance government spending in certain sectors, or through the provision of emergency loans to supply chains to lubricate such processes.
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