The necessity of a low interest rate environment - or why inflation-targeting is unhelpful

MONEY supply, particularly in the form of M1 (all the cash – notes and coins – in circulation + demand deposits) and M2 (M1 + savings deposits + fixed deposits + NIDs/negotiable instrument of deposits + repos/repurchase agreements + foreign currency deposits) don’t necessarily and, by default, indicate whether monetary policy is loose or not, strictly speaking.

In other words, an acceleration in the increase of the money supply could be an indication of “loose” fiscal policy as translated into (high) budget deficits.

It's because central banks don’t control the money supply (exogenous) or centrally plan credit allocation (in contradistinction from regulation) so that instead, it’s demand-driven (endogenous) as naturally conditioned by dynamics of the (capitalist/entrepreneurial) market, no less.

This is why central banks have long ago given up on doing so (in the form of monetary targeting). See e.g., “Divorcing Money from Monetary Policy”, Federal Reserve Bank of New York Economic Policy Review/ September 2008. To quote, “In recent decades, however, central banks have moved away from a direct focus on measures of the money supply” (p. 41) and towards inflation-targeting.

Also, to quote from BIS (Bank of International Settlements) – the central bank(er) of central banks in “The bank lending channel revisited” (BIS Working Papers No 297, February 2010), “There is thus no direct link between monetary policy and the level of reserves [as the monetary base which in turn supposedly determines the money supply under the mainstream paradigm], and hence no causal relationship from reserves to bank lending”.

Then again, to truly fight and tame inflation, the policy interest rate would have to outpace GDP growth rate which of course would be counter-productive to the extreme and disastrous for the economy – the Nairu (“non-accelerating inflation rate of unemployment”) version in the extreme/”on steroids”.

Precisely, this was what the then Federal Reserve (Fed) Chairman Paul Volcker did – in an effort to slay the inflation dragon.

Raising the interest rate to a maddening 20% by 1981 resulted in a second recession which quickly followed the one in 1980. Unemployment rose to 10% by 1982.

Now here’s the clincher: “The Fed had pursued restrictive monetary policy to stabili[s]e inflation on a number of occasions in the prior two decades but, each time, inflation moved higher shortly thereafter” (“The incredible Volcker disinflation”, Marvin Goodfriend and Robert G. King, Journal of Monetary Economics, 2005, p. 982).

The argument is supported in an article by (senior adviser at the Fed) Jeremy B Rudd entitled, “Why Do We Think that Inflation Expectations Matter for Inflation? (And Should We?)” (Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board), 2021.

What Jeremy B Rudd critically points out, furthermore, is that the data analysis of the stochastic trend (i.e., open to possibility of change or deviation) of inflation and unit labour costs “… certainly seems to indicate that the long-run behavio[u]r of price inflation and labo[u]r cost growth is linked”.

In “Systematic Monetary Policy and the Effects of Oil Price Shocks” (Ben Bernanke et al, Brooking Papers on Economic Activity, 1997), vector autoregression (VAR) runs (i.e., capturing the relationship among multiple variables as they change or develop over time) were conducted.

The finding which formed the thesis is that it’s (central bank) monetary policy (i.e., in the form of interest rate hikes) in reaction to oil price spikes that creates economic downturns. And not the oil price spikes.

For a non-technical outline and summary, refer to “Here's That Ben Bernanke [now former Fed Chairman] Paper on Oil Shocks and Policy Blunders that Everyone is Talking About” (Business Insider, March 8, 2011).

Here’s the thing – the impact of the oil spike was temporary (transitory) as compared to the impact of monetary tightening.

Step-by-step interest rate increases – as the “only” way to effectively combat inflation (as is expected of the Fed now) – would only serve to increase the cost of living by exacerbating inflation.

When applied to Malaysia with a cost-of-living crisis in the making, this makes the idea of reintroducing GST later on, even at a lower rate, to be unpalatable. Furthermore, it might jeopardise the recovery.

As highlighted in EMIR Research article, “EPF in a low interest rate environment” (February 23, 2022), there’s an observed, long-run, positive correlation between interest rates and the price levels (in that low interest rates correlate with low prices) – known as Gibson’s Paradox.

This is unsurprising since growth of the money supply is endogenous (demand-driven), even under the gold standard (at least, indirectly).

As it is, the period of the “secular stagnation” post-Great Financial Crisis (GFC) – understood in terms of the relationship between low interest rates and low inflation – has only confirmed Gibson’s Paradox.

What about hyper-inflation?

Taking the case of the Weimar Republic (1920s) and Zimbabwe (late 2000s), the increase in prices preceded money printing.

In the case of the Weimar Republic, increase in the general levels of price was due to the depreciation (price structuring) of the then Mark. In turn, this was originally caused by reparation demands which compelled the Weimar government to deficit spend to purchase foreign currencies and gold.

And as a result of inadequate taxation to offset that, this meant that deficit spending in general then outstripped the available productive resources which was exacerbated by the expropriation of the Ruhr industrial heartland by the Allies in order to exact payment under different forms.

The increase in the circulation of notes only came afterwards to accommodate the ever-rising spending by the private sector (as a result of increased deficit spending by the State, i.e., to keep up with the higher prices and) in competition with the State.

As for Zimbabwe, the destruction of the productive capacity of the economy upon which 70% of the nation depended, i.e., agriculture through land expropriation of European-owned farms, resulted in shortage of foreign earnings needed to purchase imports which quickly became a supply-side (i.e., supply shortage) issue. The corresponding rise in the general price levels then led to money printing to accommodate demand.

As noted by renowned economists Joan Robinson and Nicholas Kaldor, prices of production were set by costs (mostly labour input and interest rates). It’s quantities that are determined by effective demand.

While banks would further profit from the interest rate rise(s) since their net interest margin (NIM) would have more “breathing space”, it’ll be counter-productive as the rate hike wouldn’t be one off but a series to fend off the inflation threat.

This could result in the rise of non-performing loans (NPLs).

Low interest rates are needed to rebuild our SMEs to be the driver and engine of growth and employment – to be at the forefront and arrow head of our country’s external/trade/current account surplus.

We can’t over-rely on our MNCs since over the years, repatriation of earnings (made worse by the pandemic) have actually diluted the value of the trade surplus.

In terms of our own domestic market, the impact of increasing interest rate might feed into housing or real estate inflation. As it is, the current supply-side/supply-chain bottlenecks have fed into construction costs.

A rise in the interest rates – on the basis of so-called “policy normalisation” – will also send a wrong signal to speculators, further fuelling prices and distorting the housing market. In turn, higher interest rates will see core inflation going up.

Since inflation is mainly a pricing phenomenon (though not necessarily and exclusively so), it means that it’s driven by changes in price structures whereby the underlying bases would also be cartel or price-fixing (as part of the supply-side issues).

EMIR Research article entitled “Improving cross-border e-commerce logistics urgently required” (Dec 28, 2022) have highlighted about the shortage of logistic infrastructure, i.e., containers, during the Covid-19 pandemic as one critical reason too.

This is why fiscal deficits are not inflationary set against the context of the pandemic.

In general, this is especially so when driven by investments in technology and productive capacity – the technology deflation phenomenon.

Inflation is expected to moderate by second half of the year as supply-chain/supply-side issues are sorted out (including geopolitical tensions) as well as when cartel activities, i.e., production-fixing (OPEC – geo-economic vicissitudes) and price fixing (US – corporate interests) in oil and gas “tires out” (meaning market “self-corrects” or forced by external, e.g., domestic regulatory, forces including a possible windfall tax).

And not least post-Russia-Ukraine conflict.

In another EMIR Research article, “Monetary policy need not be tied to interest rate manipulation” (February 17, 2022), we talked a bit about the tapering down of QE i.e., the slower pace of QE.

This will lead to balance sheet reduction eventually, with the concomitant of long-term repo selling by the Fed at a higher price than the original selling price (i.e., by the banks to the Fed via QE – asset swap operation) which upon the exchange signals interest rate hike from the Fed. This would lead to higher yields and, therefore, lower principal price.

Generally, the higher coupon payments would lead to higher income of the private sector and hence additional spending capacity into the economy, thus fuelling inflation at a time when the supply-side issues aren’t still resolved.

At the same time, as pointed by veteran financial analyst and commentator, Pankaj C Kumar in “Honey, I shrunk the balance sheet” (The Star, February 12, 2022), this would adversely impact the asset prices and valuations of the equities – with implications beyond the US.

To conclude, this is why monetary policy shouldn’t be tied down to or hamstrung by interest rate manipulation by the central bank.

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Jason Loh Seong Wei is Head of Social, Law & Human Rights at EMIR Research, an independent think tank focussed on strategic policy recommendations based on rigorous research.

** The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the position of Astro AWANI.