Decoded: Why central banks hike interest rates to tame inflation 

The US Federal Reserve on Wednesday raised its interest rates by 25 basis points to a range of 5.25-5.50 per cent, the highest in 22 years. Across the Atlantic, the European Central Bank, which regulates the euro zone, also raised its rates by 25 basis points to 3.75 per cent, the highest level since 2000-01.

Aggressive rate hikes are not limited to the United States or the euro zone. Sixteen of the the G20 countries – the biggest economies in the world – have raised rates over the past year. The only exceptions to this trend are Japan and China – the world’s third-and second-largest economies respectively.

China has been cutting rates intermittently in order to boost its flagging economy. In June this year, its central bank cut a key medium-term lending rate from 2.75 per cent to 2.65 per cent. Japan, on the other hand, has been following an unconventional monetary policy, wherein the interest rate is near-zero.

But one country took the cake when it came to its monetary policy: Turkiye. The country took a contrarian approach and began cutting rates from the end of 2021. This however led to the Turkish Lira losing about 60 per cent of its value and burdening the government with high debt.

But whether countries hiked or cut interest rates, there has been one common factor influencing these decisions – high inflation.

‘Black swan’ events and inflation

When author Nassim Nicholas Taleb coined the term ‘Black Swan’ in his book of the same name, he may not have imagined the enormous impact of the word on the global economy. A ‘black swan’ event is an unexpected and random incident which has a long-lasting impact on the economy.

The Covid-induced global lockdowns and the ongoing Ukraine war are clearly ‘black swan’ events. The twin events, which hit the world within a gap of two years, continue to disrupt the global supply chains and commodities markets, leading to a slowdown in the global economy and massive inflation worldwide.

Global inflation continues to be above the pre-pandemic (2017-19) levels of 3.5 per cent. According to the International Monetary Fund’s forecast, the global headline inflation — this includes prices of food and energy — stood at 8.7 per cent last year. It fell to 6.8 per cent in 2023 and is expected to further decline to 5.2 per cent in 2024.

The inflation monster has eaten into the pockets of people living in advanced as well as poorer countries. To put inflation numbers in perspective: Venezuela had an inflation rate of 400 per cent as per a 2023 IMF estimate, while inflation in the UK is expected to be around seven per cent this year. The UK’s inflation rate is the highest among the advanced countries in 2023.  

Decoding central bank’s interest rate logic

Major central banks across the world have been raising their interest rates aggressively to combat surging inflation. In 21st Century economics, this is commonly called the ‘Taylor rule’. Named after the US new-Keynesian economist John B Taylor, the rule entails a higher interest rate when the inflation rate is higher and vice versa.

The conventional argument is that a high interest rate makes it costlier for people to borrow money. With borrowing getting expensive, consumers are forced to spend less. When spending declines, there is a fall in demand. It is therefore postulated that weakening demand will eventually reduce the price of goods.

This is precisely the logic behind global central banks rising the interest rates, when the inflation rate is not in the target range. Inflation targetting is a major monetary policy tool used by central banks to keep inflation within a tolerable range. This tolerance band varies from country to country. In the US, the inflation target is at 2 per cent. In India, the target is 4 per cent, with 2 per cent being the lower range and six per cent being the upper limit.

The conventional monetary strategy has helped countries bring down inflation, though not to the levels they believe are ideal.

Negative impact of rate hikes

High interest rates however have an unintended negative pull on the economy. The ongoing economic downturn around the world is an example of central banks prioritising lower inflation over healthy economic growth.

To be fair, it is tough to be a central banker in 2023. Two ‘black swan’ events have threatened the global economy. Some countries are on the brink of bankruptcy, while some are facing the heat of rising cost of living. So, controlling inflation has become the priority.

But eventually, no country can truly come out of economic misery by just adjusting the monetary policy. That would mean prolonged stress on the growth prospects of a country.

Higher interest rates lead to a domino effect, with severe long-term consequences for economic growth. Higher interest rates lead to a fall in consumer demand as people have less income to spend. This in turn impacts industrial output as lower demand means less production. Eventually, lower industrial performance forces companies to lay off employees, leading to a rise in unemployment.

The ongoing global economic downturn encapsulates the domino effect pretty well. Many now argue that the looming fear of recession in several advanced countries is a result of central banks continuing with unabated rate hikes.

Currently, central bankers face a two-fold challenge. They need to deliver on economic growth to avoid a recession and also tame high inflation. It will be a tough balancing act. In monetary policy, that’s called ‘soft landing’ – a situation where central banks will raise rates enough to fight inflation but without causing a severe economic downturn.