Tighter Interest Rates Will Cause Even More Economic Destruction – Analysis – Eurasia Review

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By Frank Shostak

The Federal Reserve’s policies to promote economic and price stability are a major cause of the recent acceleration in consumer price inflation. According to popular thought, the central bank is supposed to promote both steady economic growth and price stability, with the economy seen as a spaceship that sometimes glides from stability to instability.

Supposedly, when economic activity slows and falls below the path of stability, the central bank should give the economy a boost through loose monetary policy (lower interest rates and higher of the money supply), which will redirect it towards stable growth.

Conversely, when economic activity is “too strong”, the central bank should “chill” the economy by imposing tighter monetary policy, to avoid “overheating”. This involves raising interest rates and reducing monetary injections to put the economy back on a path of stable growth and prices.

Government officials and Fed officials say supply shocks from covid-19 disruptions and the Ukraine-Russia war are driving increases in the consumer price index (CPI). The Fed thus attempted to dampen demand for goods and services by raising interest rates to bring it in line with the reduced supply.

Most people think that price increases are inflation and that prices will fall if demand for goods and services is reduced with a tighter interest rate policy.

But the key factor behind the price increases is the increase in the money supply. Note that the price of a good is the amount of money paid for it. Therefore, increases in the money supply, all else being equal, implies that paying more money for goods leads to an increase in the prices of goods.

Once we accept this point, we are likely to deduce that the driver of the general price increase is monetary inflation. Now, as a general rule, general prices tend to follow increases in the money supply. It is possible, however, that if the supply of goods grows at the same rate as the money supply, no general increase in prices will emerge.

Once we accept that inflation is about increases in money supply, we can conclude that regardless of price increases, the rate of inflation will reflect the growth rate of money supply. Note that increases in money supply divert wealth from wealth generators to holders of newly generated money. This diversion weakens the process of wealth generation, thus compromising economic growth and the well-being of individuals. Conversely, a fall in the money supply reduces the diversion of wealth, reinforces the process of wealth generation and increases the well-being of individuals.

Strengthening wealth creation requires closing all monetary loopholes associated with Fed asset purchases. For example, when the Fed buys an asset, it pays for it with money generated “out of thin air”. If the asset comes from a non-bank business, it will almost immediately increase the money supply. A widening government budget deficit, once monetized by the Fed, will also increase the money supply.

Once the various money-generating loopholes are closed, the diversion of wealth will be stopped. With more wealth at their disposal, wealth creators are likely to expand the pool of wealth, laying the foundation for true economic growth.

This runs counter to a tightening of interest rates, which will not only undermine various bubble activities, but also real producers of wealth.

Like loose monetary policy, tighter interest rate policy distorts interest rate signals from consumers because it leads to misallocation of resources and weakens real economic growth. Therefore, raising interest rates to counter rising prices also undermines bubble activity and weakens wealth generators.

The following example might further clarify this point. Consider a parasite that attacks the human body and harms health. The parasite also generates various symptoms, including body pain. To fix the problem, the parasite should be directly removed. Once the parasite is eliminated, the body can begin to heal.

The other way to counter the parasite is to use various painkillers. These analgesics reduce pain but also weaken the body. The alternative risks serious harm to the health of the individual. Instead of dealing with the symptoms of inflation, the money-generating loopholes should be closed.

Closing these loopholes will stop the diversion of wealth from wealth generators and strengthen the wealth pool, which will make it much easier to manage the various side effects of liquidating bubble activities. Therefore, the recession will be shorter.

Most policymakers believe the Fed needs to raise interest rates significantly to break the inflationary spiral. Many are certain that a policy of steep rate hikes during the Volcker era broke the inflationary spiral: in May 1981, Fed Chairman Paul Volcker raised the target federal funds rate to 19.00% against 11.25% in May 1980. The annual growth rate of the CPI, which stood at 14.8% in April 1980, had fallen to 1.1% by December 1986.

Given the high likelihood that the wealth pool of the economy will be in trouble, an aggressive rise in interest rates is likely to prolong the incipient recession, turning it into a severe economic slump.

By freeing the economy from central bank interference in interest rates and the money supply, the destruction of wealth will be halted, enhancing the process of wealth generation. With more real wealth, it will be much easier to absorb various misallocated resources.

Conclusion

In response to recent sharp increases in the prices of goods and services, the Fed has adopted a tighter policy on interest rates. If the Fed were to follow the correct definition of inflation (an increase in the money supply), it would find that tight interest rate policy will seriously harm the economy. What it takes to eliminate inflation is to recognize that inflation is a matter of increasing the money supply, not increasing prices, and then act on it.

*About the author: Frank Shostak’s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact email.

Source: This article was published by the MISES Institute

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