The Myth of Controlling Inflation

Written by Imad A. Moosa

The cost of living crisis erupted as a result of the resurgence of inflation, which was ignited by the Corona Virus and intensified by Vladimir Putin. Ever since, central bankers and politicians have been telling us about their determination to control inflation and subsequently bragging about their “success” in doing that and containing the crisis. When the inflation rate reversed direction in 2023, they claimed credit for the change in the economic landscape, implying falsely that they had achieved a feat by adopting an aggressive interest rate policy. The claim of victory over inflation made by triumphant central bankers and politicians seems to be accepted by the corporate media, even though the claim falls under the banner of disinformation and/or misinformation.

Some examples are warranted. In a press conference held in July 2023, Jerome Powell, Chair of the Federal Reserve, said that “inflation has been declining for several months and is moving back down toward our 2 percent objective”. In another press conference held in July 2023, Christine Lagarde, President of the European Central Bank, said that “inflation in the euro area has peaked and is expected to decline gradually over the coming months”.  In a July 2023 speech, Andrew Bailey, Governor of the Bank of England, said that “UK inflation is expected to fall sharply over the next year”. In November 2023, Rishi Sunak, the former British Prime Minister, said that he would stick to his plan on reducing inflation, claiming “success” in halving the inflation rate. He even said the following: “On me personally if inflation isn’t halved”. In all cases, the implication is that people should thank Powell, Lagarde and Bailey (as well as Sunak) for this brilliant achievement that put an end to the misery caused by inflation. Well, the misery caused by inflation has not come to an end because inflation inflicts permanent and irreversible damage on consumers’ purchasing power and consequently their standard of living.

The wizards of central banks proclaim the control of inflation because this is what the “facts and figures” show. Let us have a look at these “facts and figures”, and for the purpose of illustration I will use US data. Figure 1 displays the US inflation rate (measured as the percentage change in the consumer price index relative to the same month of the previous year) and the interest rate (federal funds rate). We can see that the inflation rate started to rise in May 2020 and peaked at 9% in June 2022. The Fed started raising interest rates in March 2022, which (as we are told) brought down the inflation rate. Between June 2022 and August 2023, the interest rate was raised from 1.21% to 5.33%, which is allegedly the reason why the inflation rate went down from 9% to 3.72% during the same period. Surely this kind of casual empiricism provides support for the proposition that central bankers deserve their bonuses because they have been successful in saving people from the inflation dragon by cutting its head with the interest rate sword.

It is, however, not that simple. At least three observations can be used to cast a big shadow of doubt on this portrayal of events and the underlying cause-effect mechanism. To start with, if central bankers believed in the power of interest rate policy, why did Powell wait 22 months before resorting to this weapon? For some two years, while inflation was inflicting irreversible damage on consumers, central bankers and politicians were telling us that there was nothing to worry about because the acceleration of inflation was a transitory phenomenon. They were wrong. Recall also that these same central bankers took interest rates to record low levels and in some countries to negative territory.

The second observation is that interest rate policy is supposed to work with a long time lag because it takes time to change the behaviour of consumers. Economists talk about inside lag (the time needed for gathering information, processing information and making decisions) and outside lag (the time needed for policy dissemination, implementation and for the policy to take effect). Figure 1 shows that the Fed started to raise interest rates in March 2022 and that (consequently, as they claim) inflation peaked three months later, in June 2022. This is too good to be true, which means that the 2023 decline in inflation must have been brought about by something else. The observed negative correlation between inflation and interest rates during the period June 2022-August 2023 does not necessarily mean that a higher interest rate reduced the inflation rate. It is correlation, not causation.

Figure 1: US Inflation Rate and Interest Rate (%)

The logic behind the use of interest rate policy to control inflation works as follows: higher interest rates reduce the propensity to borrow and spend, which means that interest rate policy may (only may) deal with demand-pull inflation only, which arises when there is excess demand for goods and services (or when, as economists describe the phenomenon, too much money chases too few goods). In reality, however, recent inflation has been generated by supply-side factors, including a shortage of semiconductor chips, rising energy and food prices, global supply chain disruption and soaring profit margins. In other words, it is a combination of cost-push and profit-push inflation rather than demand-pull inflation. The Bank of England attributes 80% of inflation in the UK to global shortages and the jump in the prices of goods set on global markets, such as oil (not to forget the adverse effect of Brexit). If that were the case, the Bank of England could not have done much about it with its limited bag of tricks.

If the 2023 slowdown in inflation was not caused by higher interest rates, what caused it? The simple explanation is that it was caused by falling energy and food prices and the resolution of the chip and supply chain crises, all of which are supply-side factors. The facts and figures support this proposition.  Figure 2 shows changes in the prices of goods and services in 2022 and 2023. In 2023, as we can see, prices either rose moderately or declined. This cannot be the effect of interest rate hikes because the demand for food, energy and any necessary item is not sensitive to changes in interest rates. I am yet to hear about someone who was planning to take a bank loan to invite some friends for dinner in a restaurant, only to send an apology, stating as a reason the rise in the interest rate charged on the loan from 1% to 4%. The same goes for electricity. The same goes for recreation, even though I can imagine someone applying for a bank loan to finance the purchase of a ticket to see Taylor Swift in action. This, however, is more like a rare exception than the rule.

Figure 2: Changes in the Prices of Goods and Services

Even if the prices of food and energy had not gone down or moderated in 2023, the inflation rate would have reversed direction, simply because a continuously rising inflation rate requires explosive growth in the CPI, which is only observed under hyperinflation caused by excessive growth in the money supply. Except under hyperinflation, the inflation rate is described by economists as a stationary, mean-reverting process, which means that it has the tendency to go back to its mean value.

The proposition that the inflation rate does not keep going up for an extended period of time is supported by US data on the CPI, going back to the 1940s. The record for the number of consecutive months during which the inflation rate rose was 16 (December 1978 to March 1980). On another occasion, the inflation rate rose in 15 consecutive months between February 1950 and April 1951. More recently, the inflation rate rose for seven consecutive months between December 2020 and June 2021, then for another seven months between September 2021 and March 2022. In all of these episodes, the inflation rate reversed direction, with or without the use of interest rate policy.

The (implicit) claim that the crisis is under control because the inflation rate has peaked and started to decline represents misinformation and/or disinformation because as long as the general price level (proxied by the CPI) rises, the purchasing power of consumers gets eroded, which means that people become progressively poorer. In Figure 3 we can see the decline in the purchasing power of American consumers as a result of resurgent inflation. Between May 2020 and June 2022 (when inflation peaked) consumers lost 13.3% of their purchasing power (and therefore their standard of living). The erosion of purchasing power did not come to an end when the inflation started to decline because since July 2022, American consumers have lost a further 6.4% of their purchasing power. This loss is permanent, irreversible and can only be dealt with by income support or an outright fall in the CPI.

Central bankers find it convenient to talk about the inflation rate (which is reversible) rather than the general price level (which is not, except under the rare condition of deflation). They focus on the inflation rate because they claim credit for something that happens naturally. It is a more difficult task to do something about the erosion of purchasing power, which requires income support and consumer protection.

Figure 3: The Consumer Price Index and Purchasing Power

The last point I want to make here is about the myth that raising interest rates constitutes an anti-inflationary policy. The truth is exactly the opposite because interest payments represent a cost of production, which is typically passed on to consumers in the form of inflation. When mortgage payments go up, as a result of higher interest rates, landlords react by raising rents, which is inflationary. Raising interest rates further to bring inflation down leads to further hikes in rents and further acceleration of inflation. Interest rate policy, therefore, is counterproductive. It is useless at best and destructive at worst.

The fact of the matter is that in a neoliberal economy, where income and wealth are redistributed from the poor and middle class to the rich and super-rich, raising interest rates does just that by transferring bigger chunks of the incomes of mortgage holders to banks. Bankers get fat bonuses and the politicians who allow the extravaganza get rewarded with nice jobs when they leave public office. The status quo is not pleasant at all. It remains to say that believing that central bankers can control cost-push and profit-push inflation by raising interest rates is a triumph of wishful thinking over reason.

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