Will Increasing Interest Rates ‘Fix’ Inflation?

Unless you are an avowed cyclist, you will probably have noticed what is happening to petrol prices at the moment. They are up. Way up. Prices in most parts of Australia are now over $2 per litre for standard motor vehicle go-go juice.

Some commentators are seeing this is a sign that inflation is surely coming, if it is not already here. Many people expect that interest rates will be increased as a way of trying to suppress that inflation. They might be, but whether that would have the intended effect is actually not all that clear.

Inflation is usually defined as a general increase in prices, such that there is a fall in the ‘purchasing power’ of a given amount of money. It is calculated as a percentage, and usually expressed in terms of the percentage change in prices over a year. Different measures of inflation assess the change in prices of different things. The Consumer Price Index (CPI) is the mostly widely used measure, and it assesses what happens to a ‘standard’ range of items that an ‘average’ household would purchase.

In a market economy like ours, there are two main reasons that prices might rise. The first is that demand for something (or many things) increases. We saw this with house prices over recent years, for example, where low interest rates encouraged more people to try to buy homes (especially houses). Supply did not increase, and so the extra buyers competed with each other to buy the houses that were available. This competition caused prices to rise.

The second reason is if supply falls. When supply falls, the same number of buyers are trying to obtain a smaller number of things. Once again, they will ‘compete’ to drive up the price.

So, in both cases, inflation arises when demand is higher than it was relative to supply. And this situation can arise when demand rises or supply falls (or a combination of both).

The cause of a particular episode of inflation is really important – especially in terms of how we respond to it. A typical response is to increase interest rates. This means that anyone with debt has to pay more in interest. Because of that, they have less money left ‘in their hands’ and this will dampen demand. Where inflation is caused by growth in demand that cannot be met by increased supply – often called an ‘overheated’ economy – this can be a good thing.

However, where inflation is caused by short supply, the case for increased interest rates is not so clear cut. Consider what is happening right now with petrol prices. Prices at our pumps are not rising because Australians are using more petrol. They are rising because Russia is a major producer of oil, and much of the world does not want to buy things from Russia just now. This means that ‘world supply’ has fallen. Accordingly, the ‘world price’ has risen.

The key part here is that the problem is worldwide. This means that there is not much that we can do in Australia to influence the price. We could raise interest rates, leaving people with less money to spend on petrol. But the change in demand for petrol here in Australia is just a small blip on the worldwide demand for the product. Petrol prices would be unlikely to change.

In this case, increasing interest rates would just mean that there are two unavoidable things that people have to pay more for: petrol and debt. This must mean that people cut back on spending elsewhere. And this cut back in spending is what the RBA has been worried about, because it would restrict economic activity. If this happens to a big enough extent, unemployment and underemployment might start rising again.

This is the main reason that interest rates have not been increased yet. The RBA is worried that (i) raising rates will not reduce prices anyway, because prices are rising due to supply issues that will not be affected by things we do here in Australia; and (ii) increasing interest rates will suppress economic growth.

There is a good chance that interest rates will increase in the next year or so. After all, they are at record low levels and cannot go down from where they are. But beware of anyone who tells you that raising interest rates will fix the economy. The rising prices in our economy are due to hindered supply caused by things like war (and floods, and bushfires, and the pandemic – oh, what a terrible few years the world has had!). Interest rates changes will not do anything to fix that supply.

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