The Battle Heats Up: Interest Rates Or Inflation

Inflation may have caught hold in much of the developing world. It has certainly started to affect on the US economy. The Fed can argue that rates near zero are necessary to fuel growth and that any inflation in the system is caused by commodities and will be short-lived. The trouble in large developing nations is much different.

China admits it has an inflation problem. It has raised interest rates, and now its economy has begun to slow. PMI growth may have been flat last month. The problem is worse in India. The Reserve Bank of India recently raised the repo rate at which it loans money to banks to 7.5%. The government’s ability to control inflation may already be beyond its means. The May inflation rate was over 9%, even though India’s GDP had the slowest growth in last five quarters– up by 7.8% which is white-hot by US and EU standards.

The highly regarded Bank for International Settlements recently put out its annual report for 2010/2011. At the core of its message is that “For monetary policy, the challenges are intensifying even as central banks extend the already prolonged period of accommodation. Dwindling economic slack and rising commodity prices have driven up the risk of inflation.”

The notion that bank interest rates must rise and that central banks must raise them assumes that one size fits all.  High commodities prices affect the entire world and must be addressed by all nations even if the costs to economic growth are high. The BIS report hints that slower growth is the price to paid for the battle against inflation.  However, it is not a battle that central banks in the US, the UK, most of the EU, and Japan can wage by themselves.

Many economists believe that the global financial system will be disrupted if banks in China and India raise rates and those in developed nations do not. If so, the disruptive imbalances in bank policy and interest rates will grow and inflation may be the result. The US economy cannot stand an increase in Federal Reserve interest rates when GDP growth has already stalled, notwithstanding the BIS suggestion.

Douglas A. McIntyre