Why Central Banks Are Trying to Squeeze You
This article was originally published on Linkedin on 06 July 2022
Inflation has become a huge global problem. To combat it, most of the world’s central banks have been raising interest rates. Why? The idea is to make you spend less by making your financial life more difficult – at least in the short term.
Higher interest rates make debt more expensive. They also put downward pressure on riskier investments such as stocks and bonds. This is because if savings accounts, for instance, become more attractive from higher rates, share prices need to be discounted to stay competitively appealing to new investors since they tend to be the riskier choice. The decline in financial asset values also has a ‘wealth effect’ – it makes us feel poorer and therefore less willing to spend when we see our portfolio down by -20%, for instance.
It seems paradoxical: Why would central banks do this at a time when inflation is already squeezing everyone? First let’s look at the cause of inflation.
What causes inflation?
Inflation occurs when there is too much money chasing too few goods and services. This can be due to at least one of three factors:
Consumer demand has surged (lockdown is over).
Supply has tightened (oil sanctions, chip shortages, lockdown-induced supply chain disruptions).
Too much money floating around (caused by years low interest rates, excessive debt and quantitative easing, which were already at unprecedented levels before going into overdrive in response to the pandemic).
Therefore, when central banks pursue a tighter monetary policy via interest rates rises, they are targeting consumer demand by trying to reduce it.
To decrease the amount of money floating around, the Federal Reserve is also engaging in the opposite of quantitative easing: Quantitative tightening. Instead of printing money to buy financial assets in order to stimulate the economy, the US central bank is selling financial assets and effectively making the money they receive disappear - thus putting breaks on the economy.
Will all this work?
It is becoming increasingly likely that multi decade high inflation and rising interest rates have brought us into a global recession. During a recession, consumer demand falls and money usually circulates less, which ought to mean inflation will fall also. If inflation is then essentially tamed, for a sustained period, the fight has been won and we can look to live in more normal times again.
However, it does not always work this way. Consumer demand could still collapse while inflation remains high since consumer demand is not the only inflationary force at play.
Moreover, higher interest rates can easily lead to sovereign debt crises. How can such swollen government debts be serviced in a much higher interest rate world? By rapidly going into more debt or substantial tax increases? How will people afford their mortgages when they switch from fixed to variable if we have say 10% interest rates?
A global economy that is so dependent on debt cannot really handle higher interest rates. It could be that we get them anyway but that may lead to a domino effect of debt defaults like we saw in 2008.
Another scenario is that central banks do not continue to be very aggressive on interest rates and let inflation erode the value of debt. Once the market figures out that the inflation fight cannot be won by central banks, asset values could change substantially.
Fortunately we do not solely rely on governments to stop inflation: New and successful businesses are routinely trying to figure out how to minimise costs and increase efficiency, be it for themselves or as a service to others. Moreover, the trends of technological advancement in renewable energy, the digitisation of the global economy, artificial intelligence and its intersection with healthcare, are all highly deflationary forces.