Wednesday, 2 February 2011

Can Interest Rates Control Inflation?

As the titanic struggle between the real economy and the financial economy intensifies, the question has arisen about using interest rates as a tool to reduce the current bout of inflation. We have argued that they would be rather a bunt instrument simply because they would address the symptom and not the cause of the disease. The current bout of inflation is the result of the rising world price of commodities. This has mainly been caused by the recovery of the Icarus Economies in Asia, it is a demand led inflation.

Raising interest rates work by dampening demand to such a point that, as sales fall, companies respond by cutting their prices (or, at least, not raising them as fast). Demand is reduced by taking money out of the economy. That money doesn’t disappear though. Instead, it acts as a wealth transfer out of the real economy and into the financial economy. No wonder that it is the banks and financial institutions who are leading the charge for higher interest rates.

Which leads us back to the politics of the current situation. For Mr Osborne’s Gamble to pay off he needs the real economy to deliver growth through investment and exports. These are not helped by higher interest rates. Which creates a dilemma. In order to collect from his gamble, Mr Osborne has to turn his back on his natural constituency in the City.

We live in interesting times!

© The European Futures Observatory 2011 / Comment / Letters - Raising interest rates is a poor tool to fight inflation

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