Dean Baker
The Hankyoreh (South Korea), July 28, 2008

See article on original website

Central banks around the world are ramping up interest rates in order to combat the prospect of rising inflation. It is not clear that this is the right route. Higher interest rates will slow growth and throw people out of work. This solution could be worse than the problem.

First, it is important to be clear on the primary source of recent inflation. The recent increase in prices has its origins in the increased demand for oil and other commodities by China and other developing countries. This run-up in prices may also be accentuated by speculation, but clearly the fundamental of increased world demand explains the bulk of the price increase.

Higher commodity prices are in turn being passed on to a greater or lesser extent in a wide variety of finished products, leading to a more rapid rate of inflation for consumers. Workers are responding to more rapid increases in the cost of living by demanding higher wages, which can in turn push inflation higher.

This is where the central banks are opting to step in. The idea is to raise interest rates to slow inflation, but it is important to keep in mind the process involved. Central banks will not be able to roll back the price of oil or rice by raising interest rates. A slowdown in even the largest economies will at best only have a limited and temporary impact on the world price of these commodities.

If we are in an era where we are approaching the limits of our ability to increase production of some commodities like oil, then we will have to live with higher prices regardless of what central banks choose to do with their monetary policy. Of course, higher interest rates, by slowing economies and raising unemployment, can put downward pressure on wages. In this way they can contain inflation.

So the question is whether central banks should force workers to take cuts in real wages in order to offset the higher world price of oil and other commodities. There is an alternative. When economies slow, investment falls off as well. Less investment is likely to mean slower productivity growth, since new and better machinery and software is a key factor in increasing productivity.

Productivity growth - an increase in the amount that the economy produces for each hour of work - is the key to raising standards of living. If productivity growth slows, then the economy will be less able to sustain wage growth and higher living standards. In other words, if the central banks clamp down on growth as a way to slow inflation they will also be slowing the rate of productivity growth, making the economy even less able to support wage growth.

In this way the central banks may end up making the problem of higher inflation due to higher commodity prices a considerably worse problem associated with higher long-term unemployment and slower productivity and wage growth.

In fact, there is one mechanism that many central banks can pursue which will directly affect their rate of inflation without requiring a rise in unemployment. If central banks stopped buying dollars and sold some of their current holdings, their currency would rise against the dollar and currencies linked to the dollar.

This would reduce the price of a wide range of imported goods. Lower import prices can translate into consumer prices in the same way that higher commodity prices led to higher consumer prices. In effect, a higher valued currency can be an effective way for many countries to keep their inflation under control without necessarily raising unemployment or lowering wages.

Of course a higher valued currency will reduce exports, but this is likely to be a better outcome than slowing the whole economy through high interest rates. If a higher valued currency is containing inflation, then central banks may even opt to boost the economy with lower interest rates to offset any growth lost as a result of lower exports.

The decision over how much to worry about inflation, as opposed to the cost of enduring higher unemployment, is fundamentally a political one that should be decided democratically. For the public to have input on such decisions they must be made aware of the trade-offs or potential trade-offs involved.

Unfortunately, in most countries the conduct of monetary policy by the central bank is not given much attention in the media. As a result, the financial sector tends to have a disproportionate influence on the central bank policy.

In a real democracy, the central bank has to be answerable to elected officials, who in turn must be answerable to the public as a whole. In order for central banks to be held accountable, the public must be clear on the tools they use to fight inflation and that high unemployment is item #1 in the toolbox.



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