As central banks around the world are lifting interest rates at an aggressive pace and inflation persists and seeps into a broad array of goods and services, setting our global economy up for more expensive credit, lower stock and bond values, and hopefully not, a sharp decline in economic activity.
We live in an era, unlike anything we have experienced for decades, as countries around the world try to bring price increases under control before they become a more lasting part of the economy.
As inflation continues to surge, the central bank’s main tool to deal with this is to raise interest rates sharply, and keep them high for several years, even if that causes a painful recession, as it did in the early 1980s in the Western world.
How Much Pain, and How Deep of a Dip, Does it Take to Stop Inflation?
The well-respected Taylor rule recommends that interest rates rise one-and-a-half times as much as inflation, so if inflation rises from 2 percent to 5 percent, interest rates should rise by 4.5 percentage points. Add a baseline of 2 percent for the inflation target and 1 percent for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5 percent. If inflation accelerates further before central banks act, reining it in could require the 15 percent interest rates of the early 1980s.
Monetary policy however lives in the shadow of debt. US federal debt held by the public was about 25 percent of GDP in 1980 when Federal Reserve chair Paul Volcker started raising rates to tame inflation. Now, it is 100 percent of the GDP. When the Fed raises interest rates by 1 percentage point, it raises the interest costs for the Government on debt to the public by 1 percentage point, and, at 100 percent debt to GDP, 1 percent of GDP is about $227 billion. A 7.5 percent interest rate will cost the US Government about $1.7 trillion.
Where Will Those Trillions of Dollars Come From?
Congress will have to drastically cut spending or find ways to increase tax revenues. Alternatively, the US Treasury could try to borrow additional trillions but for that option to work, bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest.
Even if investors are confident that this will occur, we cannot assume that they will remain so indefinitely, especially if additional borrowing serves only to pay higher interest on existing debt.
Even for the United States, there is a point at which bond investors see the end coming and demand even higher interest rates as a risk premium, thereby raising debt costs even more, in a spiral that leads to a debt crisis or to a sharp and uncontrollable surge of inflation. Suppose the US government could borrow arbitrary amounts and never worry about repayment. In that case, it could send its citizens checks forever and nobody would have to work or pay taxes again but unfortunately, we do not live in that utopian world.
In sum, for higher interest rates to reduce inflation, they must be accompanied by credible and persistent fiscal budgeting, now or later. If the fiscal tightening does not come, higher interest rates will eventually fail to contain inflation.
So How Did the US Succeed in Avoiding Spiraling Inflation in the ’80s?
In the ’80s in response to the crisis, the US undertook a series of important tax and microeconomic policy changes, most notably the 1982 and 1986 tax reforms, which sharply lowered marginal rates. As well as market-oriented regulatory reforms starting with the Carter-era deregulation of trucking, air transport, and finance.
Then the US experienced a two-decade economic boom. A larger GDP boosted tax revenues, enabling debt repayment despite high real interest rates. By the late 1990s, strange as it sounds now, economists were worried about how financial markets would work once all US Treasury debt had been paid off.
The boom was a result of these monetary, fiscal, and microeconomic reforms, though we do not need to argue the cause and effect of this history. Even if the economic boom that produced fiscal surpluses was coincidental with tax and regulatory reform, the fact remains that the US government successfully paid off its debt, including debt incurred from the high-interest costs of the early 1980s. Had it not done so, inflation would have spiraled.
How is The World Responding Now?
Global economic policymakers began responding in earnest this year, with at least 75 central banks lifting interest rates, many from historically low levels. While policymakers cannot do much to contain high energy prices, higher borrowing costs could help slow consumer and business demand to give supply a chance to catch up across an array of goods and services so that inflation does not continue indefinitely.
In the UK, the central government is capping energy costs and lowering taxes, to encourage growth and hopefully curtail inflation that has been rumored to peak at 18% or even 22%!
“I Wouldn’t Say We’re at Peak Tightening Quite Yet, We Could Get Much Worse”
Freezing energy prices is an extraordinary measure, but these are extraordinary times. If the energy prices in the UK are allowed to rise by over £2,000 this winter, it will lead to destitution for British families with a devastating recession to follow, which comes after a decade of stagnation. Freezing energy prices will help British families survive the winter – curtail inflation and raise economic growth.
“It is going to be a tough 2022 — and possibly an even tougher 2023, with increased risk of recession,” Kristalina Georgieva, the MD of the International Monetary Fund, said in a blog post recently.
“I wouldn’t say we’re at peak tightening quite yet,” said Brendan McKenna, an economist at Wells Fargo. “We could get much worse.”
A key question is what that will mean for the global economy. The World Bank in June projected in a report that global growth would slow sharply this year but remain positive. Still, there is a “considerable” risk of a situation in which growth stagnates and inflation remains high.