The global economy is once again faced with its spectrum inflation, a phenomenon that central banks are re-prepared to fight. An important share of this new inflationary rise is a direct consequence of the war that Donald Trump has waged in Iran.
The United States military attacks, which began at the end of last February, caused rapid ejecting of international oil prices, with the barrel quickly exceeding the $100 barrier.
This powerful energy shock has already spread throughout the real economy, pushing inflation to the highest level recorded for almost three years.
The monetary policy of high interest rates fails to halt inflation, strengthening banking profits
As monetary policy makers suggest that they are ready to move on to new interest rates increases in response, serious questions arise as to the real effectiveness of this approach.
Economist Paul De Grauwe notes in Social Europe that, by studying current data, the reasonable question arises as to how effective interest rate policy was in the suppression of inflation during the previous major crisis, namely, the period 2021-2023.
This period is the ideal mirror for today, as, just like the current situation, it was mainly due to a shock of supply related to energy, rather than an uncontrolled, excessive increase in total demand.
The slow reaction of central banks
The historical flashback on the economies of the US, the United Kingdom, the Eurozone, Sweden and Canada from 2020 onwards reveals critical conclusions.
Initially, inflation was observed to have accelerated at unimaginable speed, climbing from practically zero levels in late 2020, to a peak that reached 10% during the second half of 2022.
However, after this peak, the fall was equally rapid, as in most countries inflation returned close to the 2% target within a period of one to two years.
The most impressive element is the remarkable slowness with which all central banks reacted. As a rule, they waited more than a whole year after inflation exceeded the 2% threshold to start the monetary tightening.
With the sole exception of the United Kingdom, interest rates increased substantially only when inflation had almost reached its peak. The European Central Bank (ECB), for example, went on to increase its basic interest rate from -0.5% to zero only in July 2022, at a time when inflation had already climbed to 8.9%.
The reasoning behind this waiting attitude was the conviction of bankers that the inflationary phenomenon would be transient, an estimate that ultimately proved absolutely correct.
The weakest point of monetary intervention lies in the time lag. A huge volume of empirical studies shows that the period between interest rate changes and their actual effects on inflation is extremely long.
As a rule, this delay exceeds one year, with most estimates converging to a delay of between 1.5 and 2 years before an increase in interest rates affects prices. As Milton Friedman had pointed out as early as the 1960s, monetary policy delays are «long and variable».
The central banks went on to raise interest rates within a time window of about 1.5 years. In other words, at the very moment when monetary tightening was applied, it was impossible for these increases to have already affected inflation.
However, inflation fell sharply at the time. Therefore, rapid de-escalation had nothing to do with the decisions of central banks, but was guided by the evolution of fuel costs.
Supply shock against demand shock
Comparison of rates of general inflation with changes in fuel prices is revealing. The fluctuations in fuel prices are more than ten times greater than the fluctuations in the general price level, and even before inflation by six to 18 months.
In 2021-2023, the problem was primarily a shock of supply, where energy prices were launched due to the war in Ukraine and the disturbances from the pandemic.
Central banks are unable to effectively combat cost-based inflation, as the increase in interest rates does not reduce fuel prices, nor does it end wars and pandemics.
High interest rates do not combat supply inflation
In theory, a central bank could increase interest rates so dramatically as to cause a deep, artificial recession, reducing production and income to drop demand for oil. But the enormous economic and social cost of such a move makes it wrong.
Oil shocks tend by nature to weaken and the best way for a central bank is to show patience. On the contrary, when inflation comes from an excessive demand shock, then and only then the increase in interest rates is indeed effective.
Great banking profits and the end of returns
In addition to its fundamental inefficiency, the policy of 2021-2023 has been extremely problematic due to the internal mechanisms of the central banks themselves. The way interest rates increase is by strengthening the rate of remuneration paid to the reserves held by commercial banks in them.
As a result, the fight against inflation was translated into a transfer of huge sums of money to commercial banks. These transfers greatly expanded banking profits, accounting for more than 50% of total banking profits in the Eurozone in 2023-2025.
This aid gave banks a strong incentive to extend the loan, completely cancelling the central bank's initial objective of reducing credit.
At the same time, this practice has caused enormous damage to the balance sheets of the central banks themselves, which have been forced to stop making profits to the national finance ministries, since these have evaporated.
A new, dangerous mistake ahead
It is impressive that, despite the clear history of failure, central banks continue to resort to interest as a means of combating exogenous shock inflation.
Today, with the background of the explosion of energy prices due to the war in Iran, the ECB and the US authorities are preparing a new round of increases.
Once again, the system seems ready to recruit a tool that will not work, causing only huge fiscal and social costs.
- Paul De Grauwe is a prominent Belgian economist and professor of European Political Economy at the London School of Economics European Institute (LSE). He is recognised worldwide as one of the leading scholars in matters of monetary union, macroeconomic policy and European integration.
