ghosh55_Sean GladwellGetty Images_inflation Sean Gladwell/Getty Images

The Monetary Tightening Trap

Governments and central banks in the US and Europe continue to insist that raising interest rates is the only way to tame soaring prices, even though it is abundantly clear that this approach is not working. The misguided over-reliance on rate increases will likely lead to economic disaster in low- and middle-income countries.

NEW DELHI – The Spanish-American philosopher George Santayana famously warned that “those who cannot remember the past are condemned to repeat it.” But sometimes even those who can recall the past have a selective memory and draw the wrong conclusions. This is how the global policy response to the current bout of inflation is playing out, with governments and central banks across the developed world insisting that the only way to tame soaring prices is by raising interest rates and tightening monetary policy.

The Volcker shock of 1979, when the US Federal Reserve, under then-chair Paul Volcker, sharply increased interest rates in response to runaway inflation, set the template for today’s monetary tightening. Volcker’s rate hikes were intended to combat a wage-price spiral by increasing unemployment, thereby reducing workers’ bargaining power and depressing inflationary expectations. But the high interest rates triggered the largest decline in US economic activity since the Great Depression, and recovery took half a decade. Volcker’s policy also reverberated around the world, as capital flowed into the United States, resulting in external debt crises and major economic downturns that led to a “lost decade” in Latin America and other developing countries.

But the context for this heavy-handed approach was very different from current conditions, because wage increases are not the main driver of inflationary pressures. In fact, even in the US, real wages have been falling over the past year. Yet that has not stopped some economists from arguing that higher unemployment and consequent larger declines in real wages are necessary to control inflation.

To continue reading, register now.

Subscribe now for unlimited access to everything PS has to offer.


As a registered user, you can enjoy more PS content every month – for free.