• Sat. Jul 13th, 2024

Central banks worldwide are increasing interest rates due to persistent inflation

Jul 2, 2023

Recently, I mentioned that central banks worldwide are increasing interest rates due to persistent inflation, despite statistics indicating a stable economy. However, a few days ago, The Wall Street Journal attempted to explain why this contradiction exists. In essence, the lockdowns during the pandemic created distortions that are masking the true economic statistics, even as a recession gains momentum.

Now, let’s take a step back and examine what a recession means in classical or Austrian economics. It occurs when central banks initiate significant changes in interest rates, which ultimately dictate production. Initially, central banks make money cheap to artificially stimulate the economy and make politicians appear successful. This leads to the financing of unsustainable loans, including those for weak businesses that only thrive due to the cheap money. To draw a parallel, it’s like suspending the principle of survival of the fittest. The weak businesses receive more money, resulting in a “boom.”

However, this boom is followed by a bust because low interest rates trigger inflation. Central banks combat inflation by abruptly increasing rates, causing these weak businesses to fail en masse. This leads to unemployment, uncertainty, and a reduction in spending by customers, consumers, and businesses. Additionally, higher debt payments resulting from rate hikes further exacerbate the situation. In this model, we find ourselves in the bust stage, where mistakes are being purged.

During the lockdowns, however, governments injected trillions of dollars into the economy and kept interest rates near zero for an extended period. Consequently, numerous mistakes were made during this time. Much of the money provided to individuals was spent on government benefits, effectively making it a permanent addition to their income. Furthermore, with most activities shut down, people were unable to spend their money on vacations or dining out, leading to a significant increase in the savings rate, which rose from single digits to 35%. As a result, there are now millions of people out of the labor force, which partly explains why unemployment numbers appear favorable. Additionally, disability payments, which can last a lifetime, contribute to reducing the official unemployment rate. Lastly, due to disrupted supply chains, individuals were unable to upgrade their cars or build new homes, resulting in a substantial backlog of old cars and unfinished housing projects.

When we consider these factors collectively—high savings, a significant number of individuals out of the labor force, and the backlog in durable goods like cars and houses—we realize that the positive statistics are a result of distortions and rebounds rather than healthy growth. Although the economy appears to be growing, it is important to recognize that these statistics are not reflective of genuine, sustainable growth.

The concern lies in central banks relying solely on these statistics without fully understanding the underlying issues. This increases the risk of making a significant policy error akin to Wile E. Coyote standing under a giant rock, waiting for it to fall. If central banks abruptly apply the brakes without considering the true state of their economies, they run the risk of plunging their economies into a severe downturn. As Chicago Fed President Goolsbee recently stated, we must be cautious and observant, as the potential for policy errors is significant.

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