Four decades ago, then US Federal Reserve chair Paul Volcker responded to double-digit inflation by hiking the federal funds rate from an average of 11.2% in 1979 to a peak of 20% in June 1981. The “Volcker shock” triggered a double-dip recession in 1980-1981 and the unemployment rate soared to more than 10%.
In a New York Times article, economist John Kenneth Galbraith wrote: “Our economy has been buffeted by cost increases posed from outside, the most important being Opec. Food is also outside. To try effectively to wipe out hard‐core inflation by squeezing the economy is possible but disproportionately costly. It is burning down the house to roast the pig.”
This year Fed chair Jerome Powell has increased the federal funds rate from a maximum of 0.25% to 3.25% to slay an inflation rate of 8.3% in August. There will be more rate increases, to 4.5%, according to most economists, by the end of the year. Leading central banks — only Japan and China are resisting the trend — have also raised their policy rates.
Critics say central banks have gone too far, too fast. That the medicine — inducing a global recession that will throw millions of people out of work — will be worse than the disease. They say central banks do not have the policy tools to directly address supply-side shocks that have already started to fade.
During Powell’s testimony before the US Congress Democratic Party representative Ayanna Pressley said: “There’s an adage that if all you have is a hammer, everything looks like a nail. The Fed knows that raising interest rates will not address the root causes of rising prices. We need a more sophisticated toolkit.”
Internationally, countries have implemented measures that directly address supply-side inflation. After incurring large increases in public debt to support their economies during the pandemic, they have resorted to fiscal policy measures to address the cost-of-living crisis.
Germany has announced a €300bn package — 8.4% of GDP — to shield individuals and companies from rising prices. It includes a cap on gas and electricity prices. Japan has kept interest rates at -0.1%, spent $54bn to support the yen and dished out $350 each to low-income households. The US has implemented the Emergency Price Stabilisation and Inflation Reduction Acts, which include industrial policies that increase investments in energy security, measures to address corporate profiteering, and powers to introduce strategic price controls.
In SA, the Reserve Bank’s decision to increase interest rates by 275 basis points since November 2021 is monetary policy madness in an economy that has been battered by the worst power blackouts in history. It is the 21st century equivalent of burning down the house to roast the pig. Interest rate increases are meant to reduce demand in an overheating economy that has too much money chasing too few goods. In SA the problem is there is too little demand. According to Stats SA, large industrial companies had spare capacity of 22.8% in May 2022 because there was no demand for the goods they produced. Increasing interest rates will only result in more spare capacity.
SA’s inflation rate of 7.6% is lower than that of many advanced economies, but its real interest rates are higher. Core inflation is only 4.4%. Inflation has peaked and will decline over the next year because supply-side shocks are transitory and work themselves out of the system through base effects. A global recession will result in subdued oil prices.
US inflation has also peaked. “Most forecasters believe inflation in America will fall from the present 8% to 4% in 2023,” The Economist says. The Fed will soon stop increasing rates and the dollar’s rise will reverse. If the SA government was serious about reducing inflation it would provide basic income to vulnerable households and subsidies for taxi owners, make large reductions to the fuel levy and cap electricity price increases at the midpoint of the inflation target.
• Gqubule is research associate at the Social Policy Initiative.
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