Raising Interest Rate can curb inflation in the US, but may lead to deflation in HK
On March 16, the U.S. Federal Reserve announced a 0.25% rate hike, which is in line with market expectations. This is the first rate hike since the normalization process of interest rates was stopped in 2019. Even though the rate hike is mild, but the FED announced that there will be another six rate hikes in 2022. It is because of the rapid deterioration of inflation. The latest US inflation rate in February has risen to 7.9%, breaking the record of the past 40 years. Increasing inflation rate is a common phenomenon after the interest rate cut due to the outbreak of COVID-19, many countries have raised interest rates to curb inflation.
Hong Kong follows the US to raise interest rate
The situation in Hong Kong is quite different. The latest reported inflation rate in January was only 1.2% (1.6% in February), the government has even implemented measures to boost the economy, including a distribution of HK$10,000 electronic currency to each adult in Hong Kong. However, based on the linked exchange rate mechanism, the Hong Kong Monetary Authority announced to follow the United States to raise interest rates by 1/4%. Raising interest rate is to cool down the economy so as to curb inflation. It can lead to deflation in Hong Kong as the current inflation rate is relatively low.
Why raising interest rate can curb inflation
First of all, why can raising interest rates curb inflation? Inflation refers to a general rise in prices. During the period of high inflation, the living expenses of the people have been rising continuously. The government and the central bank did not stop the rise in prices, but instead tried to increase interest rates. It make the lives of people in debts even more difficult. Many people do not understand why raising interest rates can curb inflation, and why government should raise interest rates during periods of high inflation, rather than reducing prices.
Turkey’s monetary experiment
If you disagree with the monetary theory that raising interest rates can curb inflation, you are not alone. The President of Turkey does not agree either, he even ordered a reduction of policy rate by 100 basis points to 14% when inflation rate exceeded 20% at the end of last year (Yiu, 2021).
After three months now, Turkey’s latest inflation rate in February rose sharply to 54.44%, an increase of nearly 1.5 times in the first quarter! The inflation rate in the same period a year ago was only 15.6%, that is an increase of 3.5 times in one year! Turkey’s experiment on real interest rate theory once again proved that cutting interest rates will only lead to higher inflation.
Figure 1 shows that Turkey’s inflation has continued to rise, reaching as high as 48.69% in January before Russia’s invasion of Ukraine on February 24. Inflation has led to a sharp depreciation of the currency. It is reported that in order to restore citizens’ confidence in the currency, the Turkish government has provided citizens with a guarantee that they can be exchanged for US dollars at a fixed exchange rate in the future, but it is still unable to prevent the decline of the Turkish lira.
“Erdogan said if lira losses against foreign currencies exceed banks’ interest rates, the government will cover those losses for lira deposit holders.” (Aljazeera, 2021)
How to curb inflation?
Curbing inflation can be roughly divided into four methods, namely (1) restricting price increases by authority; (2) increasing the supply of goods; (3) reducing the demand for goods; and (4) reducing the money supply. The first three are easier said than done, the fourth can generally be achieved by raising interest rates. Let’s discuss them one by one.
Restrict price rises by authority
This is a common tactic in authoritarian countries. No price increase is allowed by laws, and inflation will naturally return to zero! It sounds straightforward and easy to implement, but why it is not commonly used in most countries?
In fact, according to the monetary theory, inflation is not a rise in prices, but a depreciation of the currency. The same quantity of the currency can now exchange for less goods. If the prices of goods are not allowed to rise by laws, it will only lead to the emergence of black markets or the suppliers stop selling goods. It is because suppliers would not be willing to sell their precious goods in exchange for some less valuable currencies.
Increase the supply of goods
In the past, when property prices in Hong Kong rise continuously, many people believe that the only reason is insufficient property supply. However, after increasing property supply for decades, the problem of high property prices has not been solved. This is clearly because the money supply is much faster than the property supply, and unless there are some special reasons, such as a technological breakthrough or breaking a monopoly, it is hard to curb inflation (price rise) by increasing the goods supply. Taking the current global inflation as an example, oil price rise is the main cause. However, due to the serious monopolistic behavior of oil exporting countries, it is unlikely to solve the problem by increasing oil supply.
Although reducing demand can logically curb inflation, because if there is no demand, the price of goods could not be materialized. Yet in reality it is difficult, if not impossible, to request a reduction in consumers’ demand. On the one hand, many goods are necessities, such as oil and natural gas, people generally can hardly reduce demand. It is evident from the experience of environmental protection in the past ten years that reducing demand could not be achieved voluntarily. If the demand is reduced by administrative orders, the situation is like rationing (such as issuing shopping coupons with upper spending limit, like food stamps). It will inevitably incur huge transaction costs and cause unnecessary waste.
Reduce money supply
Raising interest rate is a better approach to curb inflation because of the following two benefits. First, it can directly reduce the money supply. Second, it uses market forces to attract savings with higher interest rates, thereby encouraging the reduction of consumption by market mechanism. It can minimize unnecessary transaction costs.
Why can raising interest rates directly reduce the money supply? Since the cancellation of the Bretton Woods Agreement in 1971 and turned the world into a fiat money system. Money supply is no longer limited by any standard commodity, and it can basically be increased at will.
At the level of retail banks, lending money is equivalent to increasing the money supply. Recovering loans is equivalent to reducing the money supply. As long as the interest rate is adjusted, the demand for loans can be effectively adjusted to achieve the effect of adjusting the money supply.
The impact of interest rate hikes on Hong Kong
Since raising interest rates will reduce the money supply, the purpose is to curb inflation, but since Hong Kong’s economy is currently very weak and inflation is relatively mild, raising interest rates may further depress the current moderate inflation and turn it into deflation.
In fact, the Financial Secretary has just announced to distribute HK$10,000 of electronic money to each adult citizen this year. The purpose is to boost the weak economy, which is contradictory to the purpose of raising interest rates. This is the consequence of the mismatch of the linked exchange rate system. In the past few decades, when Hong Kong’s inflation rate was higher than that of the United States, interest rate cuts stimulated Hong Kong’s economy. It results in an overheated economy, and rising property prices. But now when the inflation of Hong Kong is lower than that of the United States, but still it has to follow the United States to raise interest rates due to the linked exchange rate, it will make Hong Kong’s economy even worse and weaken the effect of the “helicopter money” distribution scheme.
Alijazeera (2021) Turkish lira rockets after Erdogan’s promise to protect deposits, December 21. https://www.aljazeera.com/economy/2021/12/21/turkish-lira-rebounds-after-erdogans-anti-dollarization-plan
Yiu, C.Y. (2021) A Turkish Experiment on Real Interest Rate, Medium, December 19. https://medium.com/discourse/a-turkish-experiment-on-real-interest-rate-edd1772604ea