Why Raising Interest Rates to Fight Off Energy Inflation is Counterproductive
By Hielke Van Doorslaer
[January 2023]
Hielke Van Doorslaer is a post-doctoral researcher in international Political Economy. His research focusses on the pivotal role inflation-targeting central banks have occupied in macro-economic stabilization efforts since the 1970’s.
These are challenging times to be a central banker. After more than two decades of stubbornly low inflation, advanced economy (AE) central banks had to abruptly switch from monetary easing to monetary tightening in order to contain newborn inflationary pressures propelled by the pandemic and Ukraine war related supply disruptions and energy price spikes. Whereas in the past, central banks were struggling to bring inflation up to target (2 percent), they are now confronted with the opposite task of trying to curb it. Around the world, inflation-targeting central banks are under pressure to demonstrate their commitment to low inflation and restore their anti-inflationary credentials. To cool inflation, most of them are resorting to aggressive interest rate hikes. During its December meeting, the European Central Bank’s (ECB) Governing Council, for example, decided to raise its key interest rates by another 50 basis points, expecting to further raise them significantly in the coming months ‘to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target’.[1]
When central banks hike short-term interest rates, they raise the cost of borrowing for households, businesses and states alike. The imagined causal chain of how higher interest rates work to cool inflation is the following: interest rates are raised, credit becomes more expensive and harder to get, businesses and consumers spend less, reducing demand for goods and services (and ultimately the workers producing these), unemployment rises, economic activity slows, and, over time, prices fall. It is clear from this, however, that raising interest rates comes at a significant cost. Higher interest rates inflict suffering on the economy by reducing employment and investment opportunities and by lowering economic growth. In addition to raising unemployment and stifling growth, the climate policy agenda will be particularly affected. Cumulative interest rate hikes would undermine important European Union (EU) goals such as energy security and decarbonization.
Rate hikes, moreover, are a blunt tool: they do not target the specific and underlying causes of the current inflationary spike directly. Essentially, rate hikes are geared towards diminishing excessive demand in the economy by slowing the entire economy (instead of targeted sectors) and curtailing both public and private expenditures. What is overlooked in all of this is that inflation is a multidimensional and multifaceted phenomenon that often has many other causes than excess demand or an economy ‘running hot’. As such, interest rate hikes will not address the root causes of today’s inflation.
Different causes of inflation require different responses
Today’s inflation is not an excess aggregate demand story, especially in Europe. Most of theEurozone’s inflation comes from volatile energy, food, and core goods components that are largely outside the influence of monetary policy.[2] Most of the drivers of the current inflationary upsurge come from disruptions in the supply of key commodities and inputs such as oil, gas, food, and microchips. Most of these disruptions resulted from the COVID-19 pandemic and its associated lockdowns and shutdowns in many industries. The effects of pandemic shortages were further aggravated by the inherent fragility of most of the global supply chains. Years of ‘just-in-time’ inventory management, focusing unilaterally on cutting costs while ignoring risks of fragmentation, had left most supply chains intrinsically vulnerable to interruptions and bottleneck problems. Until the pandemic hit, stocking up on raw materials, resources and intermediary products was deemed inefficient and pointless.[3] Further compounding this inflationary episode was the sharp increase in fuel and food prices stemming from the Russian invasion of Ukraine and the ensuing sanctions and countersanctions by the EU and Russia.
The Euro area’s current high inflation rate has therefore less to do with internally generated demand pressures than with external shocks that have raised food and energy prices in important ways. What we are seeing is inflation due to a succession of negative supply shocks that have raised food and energy prices and simultaneously depressed economic activity.[4] It is estimated that without these increases in food and energy prices, core inflation in the euro area would still be around 2%.[5] Food and energy prices are clearly the main drivers of inflation in Europe. These sectors and prices are therefore ‘systemically significant’, meaning that negative shocks to these specific sectors have a disproportionate effect on overall price stability.[6] At the same time, however, monetary policy has notoriously little control over these prices. What the ECB and other central banks are currently trying to do is fighting cost-push inflation with an instrument designed to fight demand-pull-inflation. However, when the main causes of inflation are supply-side factors and, especially, those occurring abroad, the potency of interest rate increases to fight inflation is mild at best. The costs, in contrast, will be substantial: more pain will need to be foisted on workers to extract the same gains in terms of lower inflation.[7]
Hiking rates will only mean more trouble in the long run
Today’s inflation is in essence a problem of ‘fossilflation’, driven by the ‘legacy cost of the dependency on fossil energy sources, which has not been reduced forcefully enough over the past decades’.[8] Accelerating the energy transition should be an important part of the answer to controlling both today’s fossilflation challenge and in contributing to longer term price stability. To pre-empt future inflationary shocks, governments, firms and households should be massively investing in clean energy production, energy efficiency and adaptation to increasingly extreme weather events.[9] Current central bank actions, however, work against the goal of rapidly transitioning away from fossil-based energy production by disincentivizing the necessary new green investments.
Monetary tightening raises the cost of capital, and this hits renewable technologies excessively hard.[10] Sustainable technologies are more capital-intensive than fossil-based technologies, requiring larger upfront investments, and, as such, become comparatively more expensive when central banks use monetary policy to raise the cost of financing. The higher capital-intensity of renewables makes them more vulnerable to interest rate hikes. Raising interest rates across the board therefore risks derailing the transition by inflicting a form of ‘green collateral damage’ on the economy.[11] By making credit more costly, central banks risk delaying the necessary investments in energy efficiency by both households, businesses and governments. Because of central bank actions, private actors are now faced with a higher cost of credit for renovation loans and a higher cost of materials and services (due to supply-induced inflation).[12] Higher interest rates also raise the borrowing costs for governments, constraining the state’s fiscal capacity for long-term investments in improved mobility, green technologies and sustainable infrastructure.
Hiking rates in a macroeconomic environment of rising energy prices therefore risks aggravating the economy’s carbon lock-in and prolonging its dependence on outdated and polluting carbon technologies.[13] Interest rate hikes are not only counterproductive in the long run - as they exacerbate both the climate change challenge and undermine central banks’ primary objective of securing long-term price stability -, they are also in direct conflict with the ‘REPowerEU’ plan tabled by the Commission in which it seeks to ‘fast forward the green transition’ by means of ‘an increase in energy savings, a diversification of energy supplies, and an accelerated roll-out of renewable energy’.[14] Moreover, the ECB riskshiking rates at a time when inflationary pressures are seen to be easing.[15] Inflationary tailwinds may then quickly turn into deflationary headwinds. Martin Sandbu has likened this effect to a ‘ketchup bottle’, where shortages can quickly turn into gluts.[16] This risk is especially real when a sudden ease in price pressures coincides with a zealously overtightening central bank, possibly pushing the Eurozone into a recession. In that case demand will falter just when supply capacity is picking up, driving prices down instead of up.
What central banks are overlooking in all of this is that the biggest risk today might not just be inflation but stagnation. There is a real danger that excessive tightening will leave long-lasting scars on the productive capacity and economic potential of the Eurozone’s economy. Aggressively hiking rates now will act as a fundamental drag on efforts to decarbonize the economy, rule out any transformative green agenda and put a strain on the necessary investments and innovation. It puts monetary policy at cross-purposes with other policy priorities (such as investing in renewables and energy-efficiency) and risks further entrenching years of public and private underinvestment. In this way prohibitive interest rates will further exacerbate the trend of secular stagnation (defined by low rates of growth, productivity, and investment) that has plagued advanced economies for at least a decade (with some even dating the onset of the declining trend back to the 1970’s).[17]
There is an alternative
Raising the interest rate is only one way to combat inflation. Monetary policy used to, and could again, mean more than just interest rates: e.g., qualitative and quantitative credit regulations to manage effective demand and steer investment towards specific sectors.[18] Throughout history central banks have always coordinated with ministries of finance (and other government agencies) to proactively steer credit and support major structural change of the type required by the climate crisis, complementing active fiscal and industrial policy regimes.[19] This broader policy approach is generally referred to as ‘credit guidance’ (while ‘window guidance’, ‘credit controls’ or ‘moral suasion’ are also used). Credit guidance is a technique in which central banks ‘manipulate’ and ‘shape’ the flow of credit in line with pre-established monetary and industrial policy goals. It allows for a selective macro-level direction of credit across the economy, meaning that central banks can proactively direct finance towards supporting certain ‘desirable’ sectors of the economy while simultaneously repressing others.[20] This approach would enable central banks to provide a targeted stimulus to the economy by offering preferential discount rates for green lending. In a fairly recent example, both the Japanese and Chinese central bank accorded quantity-based quotas to commercial banks to make them lend to particular sectors (including for sustainability purposes).[21]
As such, credit guidance policies could inform an alternative policy framework that articulates a more ‘market-shaping’ role for public policy, driven less by financial market incentives and more by mission-oriented economic and industrial policies geared towards structurally transforming energy, food, housing and transport systems in accordance with a rapid green transition.[22] It would allow central banks to help expand the capacity frontier of certain critical commodities and technologies, and would help speed up the roll-out of renewable and more energy-efficient technologies. Such an approach would lead to a double win for central banks: it would allow them to better safeguard long-term price and financial stability (by preventing new upshots of ‘fossilflation’ in the future) and help them curtail short-term inflation (by reducing fossil-based energy demand here and now).
Conclusion
By focusing unilaterally on price stability and ignoring other threats (such as climate change and secular stagnation), central banks are woefully unprepared to face today’s ‘polycrisis’.[23] By refusing to take on board other concerns than simply protecting price stability, central banks have trapped themselves into a corner where the only option they have is to raise rates in a desperate attempt to restore their credibility as inflation-fighters. As Daniela Gabor rightfully notes, their situation can be compared to a particular situation in a game of chess (known in German as ‘Zugzwang’) where a player is forced to make a move, while this move will only worsen the initial position the player is in.[24] The same holds for interest rate hikes in an environment of inflation predominantly driven by supply shocks and energy prices: the benefits will be trivial at best, while the costs will be large. Not just for central banks but for all of us.
Endnotes
[1] European Central Bank, Monetary policy decisions, Press Release, December 15, 2022, https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp221215~f3461d7b6e.en.html
[2] See for example: Philip R. Lane, Inflation Diagnostics, The ECB blog , November 25, 2022, https://www.ecb.europa.eu/press/blog/date/2022/html/ecb.blog221125~d34babdf3e.en.html; Joseph Politano, “The Eurozone's Unique Inflation Crisis,” Apricitas Economics, 15 January 2023, https://www.apricitas.io/p/the-eurozones-unique-inflation-crisis.
[3] Brooke Masters and Andrew Edgecliff-Johnson, “Supply chains: companies shift from ‘just in time’ to ‘just in case’”, Financial Times, December 20, 2021, https://www.ft.com/content/8a7cdc0d-99aa-4ef6-ba9a-fd1a1180dc82
[4] For a useful distinction between ‘good’, ‘bad’ and ‘ugly’ inflation, see: Fabio Panetta, “Patient monetary policy amid a rocky recovery”, Speech at Sciences Po Paris, November 24, 2021, https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211124~a0bb243dfe.en.html
[5] Karl Whelan, “Global factors and ECB monetary policy”, European Parliament Monetary Dialogue Papers, November 2022, https://www.europarl.europa.eu/RegData/etudes/IDAN/2022/733994/IPOL_IDA(2022)733994_EN.pdf
[6] Isabelle Weber, Jesus Jauregui, Lucas Teixeira and Luiza Nassif Pires, "Inflation in Times of Overlapping Emergencies: Systemically Significant Prices from an Input-output Perspective"), Economics Department Working Paper Series. 340. (November 2022), https://doi.org/10.7275/0c5b-6a92
[7] Gerald Epstein, Hiking Interest Rates Protects Financial Assets of the 1% at Workers’ Expense, Truthout, July 7, 2022, https://truthout.org/articles/hiking-interest-rates-protects-financial-assets-of-the-1-at-workers-expense/
[8] Isabel Schnabel, A new age of energy inflation: climateflation, fossilflation and greenflation, Speech at a panel on “Monetary Policy and Climate Change” at The ECB and its Watchers XXII Conference, Frankfurt am Main, March 17, 2022, https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220317_2~dbb3582f0a.en.html
[9] Katie Kedward, “Forget greenflation, central banks need to tackle fossilflation,” Green Central Banking, blogpost, May 19, 2022, https://greencentralbanking.com/2022/05/19/greenflation-central-banks-fossilflation-inflation/ ; Jens van ‘t Klooster, The European Central Bank’s strategy, environmental policy and the new inflation: a case for interest rate differentiation, Grantham Research Institute on Climate Change and the Environment and Centre for Climate Change Economics and Policy, (2022), https://www.lse.ac.uk/granthaminstitute/wp-content/uploads/2022/07/The-European-Central-Banks-strategy-environmental-policy-and-the-new-inflation.pdf
[10] For more on this, see: Hielke Van Doorslaer and Mattias Vermeiren, "Beyond normal central banking? Monetary policy after the pandemic," The European Trade Union Institute, December 2022, https://www.etui.org/publications/beyond-normal-central-banking-monetary-policy-after-pandemic
[11] Asker Voldsgaard, Florian Egli and Hector Pollit, “Can we avoid green collateral damage from rising interest rates?”, UCL IIPP Blog, June 20, 2022: https://medium.com/iipp-blog/can-we-avoid-green-collateral-damage-from-rising-interest-rates-1259ea94c9ea
[12] Uuriintuya Batsaikhan, High interest rates are a threat to the green transition, Positive Money Europe, Blogpost, Dec 7, 2022, https://www.positivemoney.eu/2022/12/high-interest-rates-threat-to-green-transition/
[13] Lukasz Krebel and Frank van Lerven, “Green credit guidance: a green term funding scheme for a cooler future,” New Economics Foundation, August 2022, https://neweconomics.org/uploads/files/NEF_GCG.pdf
[14] European Commission, ‘REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition’, May 18, 2022, https://ec.europa.eu/commission/presscorner/detail/en/ip_22_3131
[15] Claire Jones, Central banks should sacrifice ambitions of a perfect economic landing, Financial Times, January 7, 2023, https://www.ft.com/content/5b208707-3cb9-4410-9dee-1ebd8b5e6c3d
[16] Martin Sandbu, Beware the ketchup-bottle economy, Financial Times, May 23, 2021, https://www.ft.com/content/8daa2740-30de-4817-a687-c69b345095cd
[17] Jack Copley, “Decarbonizing the downturn: Addressing climate change in an age of stagnation,” Competition & Change, (2022), https://doi.org/10.1177/10245294221120986 ; see also: Lawrence H Summers, “The Age of Secular Stagnation: What It Is and What to Do About It”, Foreign Affairs, 95(2),(2016), 2–9. http://www.jstor.org/stable/43948172.
[18] Dirk Bezemer, Josh Ryan-Collins, Frank van Lerven and Lu Zhang, “Credit policy and the ‘debt shift’ in advanced economies,” Socio-Economic Review mwab041 (2021), https://doi.org/10.1093/ser/mwab041
[19] Katie Kedward, Daniela Gabor and Josh Ryan-Collins, “Aligning finance with the green transition: from a risk-based to an allocative green credit policy regime,” Working Paper IIPP WP 2022-11, UCL Institute for Innovation and Public Purpose, 2022: https://www.ucl.ac.uk/bartlett/public-purpose/wp2022-11 ; see also: Eric Monnet, “Controlling credit: central banking and the planned economy in postwar France 1948–1973”, Cambridge University Press (2018); Olga Mikheeva and Ryan-Collins J., “Governing finance to support the net-zero transition: lessons from successful industrialisations,” Working Paper IIPP WP 2022/01, UCL Institute for Innovation and Public Purpose, 2022: https://www.ucl.ac.uk/bartlett/public-purpose/publications/2022/jan/governing-finance-support-net-zero-transition-lessons-successful
[20] Naoise McDonagh, "Credit Guidance for a Desired Economy: An Original Institutional Economics Critique of Financialization," Review of Radical Political Economics 53, no. 4 (2021): 675-693. https://doi.org/10.1177/04866134211018867
[21] Richard A. Werner, “Princes of the Yen: Japan’s Central Bankers and the Transformation of the Economy”, ME Sharpe, (2003); Simon Dikau and Ulrich Volz, “Out of the window? Green monetary policy in China: window guidance and the promotion of sustainable lending and investment”, Climate Policy, 1–16 (2021)
[22] Yannis Dafermos, “Climate change, central banking and financial supervision: beyond the risk exposure approach,” SOAS Department of Economics, 2021
https://www.soas.ac.uk/economics/research/workingpapers/file155297.pdf; Mariana Mazzucato and Josh Ryan-Collins, “Putting value creation back into 'public value': from market-fixing to market-shaping,” Journal of Economic Policy Reform, 1–16 (2022)
[23] Adam Tooze, “Welcome to the world of the polycrisis,” Financial Times, October 28, 2022: https://www.ft.com/content/498398e7-11b1-494b-9cd3-6d669dc3de33
[24] Daniela Gabor, “Zugzwang central banking,” (ECB edition), Financial Times, September 8, 2022: https://www.ft.com/content/2d79d153-fffa-4441-b79f-0a808a51108f