Can double-digit inflation be brought under control with 3% interest rates?

It would’ve sounded like an absurd question not so long ago. Surely you need to raise rates to be above the rate of inflation at the very least. Otherwise, you’re still stimulating inflation.

In fact, historical central bankers would probably be horrified at the very question. The idea that interest rates are lagging inflation by double digits in parts of the developed world is downright terrifying. Don’t modern central bankers know where such policy leads?

Over at the Reserve Bank of Australia, the personnel have come under fire in the mainstream media for lacking monetary policy experience. They’re largely businesspeople, not economists. Talk about misaligned incentives. I mean, would you trust mortgage borrowers to set interest rates?

If you ask me, we should be hiring historians, not economists, to run central banks. Economists focus on recent economic data, which is why they’re accused of driving a bus by looking out the rear window. With the predictable results in 2008 and 2022, when there was a turning point.

Historians have longer memories. They might be able to remember what wild monetary policy risks cause. Perhaps they should be European historians in particular…

But back to our question. Central banks around the world face double-digit inflation. And they’re allegedly planning to hike interest rates to about 3% to bring that inflation back down…

But is that even possible?

The markets seem to think it is. In fact, they’re already pricing in rate cuts next year in some places! This implies inflation is coming back down again soon.

But how?

Well, debt levels have risen so much that it should be possible to slow inflation with piddling interest rate increases. The cost of debt will rise enough to slow inflation, even if rates are well below inflation.

The thing is, the pace of increases is going to be incredibly fast…

But that’s only because central bankers were caught out pretending inflation was still low when it wasn’t. Now they’re having to catch up with spiralling inflation instead.

Odd that the RBA’s businesspeople didn’t see inflation coming, isn’t it? I mean, they’re the ones paying the spiking producer costs and setting the consumer prices.

Anyway, it certainly is possible to bring inflation back down with interest rate cuts that don’t keep up with inflation, theoretically speaking.

The real question is whether central bankers manage to stay in the goldilocks zone — a fictional place where monetary policy is just right: not too loose and not too tight.

I say fictional because nobody knows what the right monetary policy really is. If we could know it, then central planning would work, and socialism and fascism would be economically efficient.

But we learned long ago that government intervention only distorts the economy. For some reason, we never applied the lesson to monetary policy.

And so, today, people believe that someone must ‘set’ the interest rate, just as people in the Soviet Union once believed that someone must ‘set’ production targets, prices, and allocations of goods and services. If nobody’s in charge, there would be chaos…

Back to the story, again.

The question is: Can central bankers manage to pull off one of the greatest pole vaults of all time by bringing down double-digit inflation with 3% interest rates, or whether they poleaxe the economy instead?

David Plank, head of Australian economics at ANZ, explained just how high the RBA is going to try and jump:

‘Our expectation is that the RBA will deliver this via four more successive 50 basis point rate hikes in August, September, October and November. This 200 basis points of additional tightening sees the cash rate target at 3.35 per cent by November.

‘A cash rate of 3.35 per cent implies that household interest payments as a percentage of household income peak below the level reached in 2008.’

Realestate.com.au points out this is ‘the fastest ever rise in interest rates’. I wonder what that might to do debtors.

The Bank of England is taking time off from driving armoured trucks to Ukraine, loosening mortgage rules, and opposing the government’s Brexit reforms to tighten monetary policy rapidly in the UK too.

In the eurozone, it’s a case of Fierljeppen — canal vaulting. This sport is especially humiliating to its practitioners because they must climb their pole while vaulting a canal if they don’t want to get wet.

How is the metaphor relevant? Well, the European Central Bank is so far behind its peers on raising interest rates that it’s having to scramble up the pole while vaulting the inflationary canal. And, so far, they’re climbing too slowly to stay dry, with double-digit inflation in parts of the eurozone, but negative nominal interest rates…

I’d call them lunatics, but they’re doing it right out in the sunlight, and nobody is losing their minds about it. The idea that the Germans would put up with negative nominal interest rates and inflation above 8% is insane to this German. No wonder my mum messaged me ‘Germany is being destroyed’ yesterday.

And it’s in Europe that the stakes are highest. Because the debts are too.

European governments, unlike those in the rest of the world, cannot rely on the European Central Bank to print money to finance their deficits. So, in Europe, it’s the governments themselves that could trigger a debt crisis.

And that’s my real point this week. The risk is that inflation comes back down by way of a financial crisis instead of a slowing economy. Which I think is rather likely, especially in Europe.

If you want to bring down inflation by way of making existing debt more expensive, as opposed to disincentivising more borrowing by having interest rates rise above the rate of inflation, then that implies a debt crisis of some sort. Defaults, financial crises, and busts, as well as the implicit plunging asset prices for anything that’d debt financed.

But here’s what baffles me. Such a crisis just leads to the same place — another round of QE, bailouts, and rescues.

Especially if inflation falls.

The true endgame is a situation where inflation doesn’t fall as a recession and financial crisis breaks out. But I don’t think we’re there yet…

Until next time,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend