Raising Interest Rates Will Prove Ineffective in Curbing Inflation and Could Exacerbate the Problem

Inflation, and how to curb inflation, seem to be the most important topics of the day. Many believe the Fed's current policy of raising interest rates will not work and I believe moderately higher interest rates may make the problem worse.

The Fed is in the midst of a campaign to raise its benchmark interest rate, the federal funds rate, which it began in March this year, continued in May and plans several more rate hikes this year. It will unlikely be able to raise rates enough to stem the currently 8+% annual inflation rate reported most recently in May.

The most recent example of using higher interest rates to dampen inflation dates back to 1979 when then Fed chairman Paul Volcker broke double-digit inflation by raising the federal funds rate higher than the inflation rate. Back then, Volcker reduced inflation that peaked near 15% in 1980 to less than 3% by 1983, by increasing the federal funds rate from 11% in 1979 to a peak of 20% in mid-1981. That drastic measure also led to the mild 1980-82 recession and a 10+% national unemployment rate that brought Volcker heavy criticism.

Raising interest rates above or even just to the level of today’s inflation rate, as Volcker did then, would surely lead to even more dire consequences today than they did 40+ years ago. It would most likely cause a severe global economic recession or worse, and a crash of the global bond and stock markets, which until very recently were at all time highs. So the Fed’s current half-baked plan to raise interest rates to less than half of the current 8% inflation rate is a real head scratcher as it is unlikely to curb inflation.

Why is the Fed unable to raise interest rates more? All-time high global debt in absolute terms and relative to global GDP will assure that even a modest rise in interest rates could lead to unprecedented levels of bankruptcies for individuals, businesses and governments of both industrialized and emerging nations. For example, in the US alone, the Debt-to-GDP ratio is today more than 120%, compared to a mere 30% back in 1980. Higher interest rates will likely have even more dire effects on other industrialized nations and could be catastrophic for emerging market economies.

Moreover, few observers seem to realize that the planned modest increase in interest rates with so much outstanding debt could worsen the inflation problem. Higher interest rates are already raising the cost of home mortgages and thereby home purchases, with a similar effect on auto loans and auto purchases. Back in the 1970s, the primary cause of inflation was the huge increase in energy costs, which effect just about all economic life on the planet. With today's huge and ubiquitous levels of global debt, interest rate increases similarly permeate all economic activity. There are already reports that family, business and government budgets are feeling the burden of higher interest costs from their historically high credit balances.

The Fed obviously knows all this, so what is its end game? By raising rates modestly, which it has and will continue to do, the Fed appears to be biding its time, letting some air out of the financial markets bubble, probably with the intention of persuading us by the end of the summer that that loss of wealth is reducing inflationary expectations. My best guess is that by the fall, the Fed will feel pressure to reverse course and begin to lower interest rates into the new year. The combination of midterm elections in November and the importance of fourth quarter business activity to annual budgets will provide the incentive necessary to stimulate the economy and the financial markets.