Historical experience shows that excessive inflation will hurt an economy badly. Taking their time in learning the lesson, governments tasked their central banks with the prevention of prices from rising out of control. They were also granted independence to do so. Central banks worldwide are trying to rein inflation by adjusting interest rates.
Simply put, it works like this: if there’s no inflation, rates may be cut to give citizens and businesses incentives to borrow (credit is cheap), and by spending the money, they will consume and generate additional demand, causing prices to start rising. Soaring prices are followed by rate hikes to discourage everyone from borrowing, as a result of which there will be no additional demand, and even those who have money will save it rather than spending it, because they can earn high interest on their savings.
This is all well, but I have a problem with the concept of a monetary system driven by interest rates. My problem is that it will work well only in a certain range of the parameters describing the state of the economy. Interest rates may only be an efficient means of influencing inflation where debt, foreign currency debt, wealth inequality, etc. are not excessively high, but people’s expectations for future inflation also make a difference. That’s what I call the working range of the system. Outside that range, risks and side effects will increase radically.
More precisely, this wouldn’t be a problem in itself. However, the monetary system is constructed in a way that in the course of its normal operation, it will be driven outside the working range over time. And there’s no built-in automatism that would drive the system back where it can function properly. In this respect, our monetary system resembles the nuclear plant of Chernobyl. It is possible to live with it for a few decades, but by now virtually the entire world has been driven outside the working range. Today, it’s not possible to control inflation with interest rates.
Japan has felt this since the 1990s. Over there, the central rate has been kept under 1% without any interruption for nearly 20 years with zero rates also occurring not infrequently, yet there’s been no inflation. On the contrary, they’ve experienced a series of longer periods of deflation. The reason for that at the level of national economy, the Japanese are frightfully indebted, and are unwilling to borrow more to spend, consume and generate price hikes. They also huge amounts in savings, which they won’t use for consumption. Indeed, why would they? Next year everything will be cheaper anyway and their money will be worth more, so they’d rather not spend it now. Always next year. That is to say, they’re sitting in the middle of their deflationary spiral. Despite the zero central rate, there’s no inflation.
Hungary was driven outside the working range on an entirely different course. Due to the traditionally high inflation, the central bank continuously kept its rate at a high level. This discouraged everyone from taking loans (except those subsidised by the state) until foreign currency lending took off on a mass scale in the early 2000s. The Swiss Franc and the Euro were loaned at low rates to all and sundry, and folks used their borrowings to buy plasma TVs and cars. Obviously, this generated additional demand in the economy, causing prices to increase further. In response, the central bank maintained its high rate but this failed to slow borrowing, as the HUF interest rate is not relevant to foreign currency loans. At best, the central bank managed to make the Forint attractive to foreign investors due to the high interest rate, as a result of which its exchange rate remained steady or appreciated. All this concealed the real risk of foreign currency loans; the way things looked suggested that one could only win on those loans in every respect (interest, exchange rate). That is, the central bank accelerated the growth of foreign currency lending.
Interestingly, the prohibition of foreign currency lending and the deleveraging of debt could soon push Hungary back within the working range, allowing interest rates to control inflation again. However, the central bank is apparently not patient enough for that, and by forcing a double rate system (Funding for Growth Scheme) and other measures, a new factor has been added to the system that is trying to push its state outside the working range.
Inflation can no longer be controlled through interest rates even in the US. During the latest savings crisis, such an amount of money was borrowed that a hike in real interest rates would immediately send masses of people and businesses bankrupt. Rather than risking this, they will let prices rise somewhat out of control. They may raise rates but not so much as to completely halt inflation. Until then the central rate is left at zero, yet inflation still falls short of the target (although getting closer recently). In the Eurozone, the situation is similar: the central rate has long been virtually zero with inflation far below the target; indeed in some countries prices are falling in rampant deflation.
Of course, central banks aren’t watching impassively their inability to control inflation through interest rates. Although there’s no room to cut rates, the threat of deflation is imminent. As a result, they’re trying to drive the system back within the working range by other means. They’re printing money and saving time. But all this will not be sufficient later on; without changes to the monetary system, the same problems will be generated all over again. Until then, let’s take a look at the impacts of printing money – in the next part.
Original date of Hungarian publication: 11 July 2014