interest rate spiral


The world economy has become complex in a way that no one expected and economic policy makers in many countries face a major dilemma.

This year coincides with the pandemic crisis, extreme inflation and war in Ukraine caused by the Russian invasion; Some analysts associate them with problems arising from climate change that are observed in different regions.

From 2021 onwards, inflation began an upward trend that was initially interpreted as a temporary phenomenon; It was only towards the end of that year that it began to be realized that this was an ongoing problem, so central banks reacted late.

The problem was exacerbated by the invasion of Ukraine, which hit the supply of inputs such as agricultural products, fertilizers and energy, putting more pressure on the prices of basic products. Overall, the outbreak of COVID-19 in China and its ‘zero-Covid’ policy have not allowed the problems of supply chain operations to go away.

The response to rising inflation has been the traditional increase in monetary policy interest rates. But the decision that seems appropriate when looking at an economy in isolation in a globalized world has an effect that prompts new increases in rates. As Shang Jin Wei, a professor at Columbia University, points out, when a central bank such as the Fed raises its interest rate, it has the effect of exporting part of the inflation to other countries through currency depreciation; To mitigate this, the central banks of these countries are forced to raise their intervention rates by more than necessary (the risk of competitive interest rate hikes).

The result is a spiral of interest rates that slows the growth of the economy more than desired and increases the risk of a global recession.

An additional difficulty is that fiscal policy cannot mitigate the effects of high interest rates on growth, as the massive expansion of public spending to deal with the pandemic has led to increased fiscal deficits and indebtedness in many countries.

So while there is a brake on demand due to monetary policy, there is another one due to fiscal consolidation policy.

In this context, international agreements should operate to reduce the possibility of an unnecessary recession; The problem is that the world is devoid of leaders and global institutions are weakening.

Obviously, we are facing a case of ‘tragedy of the common people’.

Hernan Avendano Cruz
Director of Economic Studies of Facecolda

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