Posted on by John Sloman

Why raise interest rates to tackle cost-push inflation?

We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?

In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.

As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.

The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.

The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.

This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.

Monetary policy response

Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?

One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.

If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.

Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.

Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.

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Questions

  1. How may monetary policy affect inflationary expectations?
  2. If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
  3. In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
  4. With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
  5. If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
  6. Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?