Is inflation always harmful to an economy – and to what extent does raising interest rates curb inflation? Sibasish Mohapatra deep dives into the roots of a phenomenon that could spark a global recession.

Is inflation due to a rise in the price of crude oil? In nations such as the United States, United Kingdom, and India, inflation rates have risen beyond a record 7 per cent even after interventions by Central Banks. More than 50 Central Banks have raised interest rates by 50 basis points or more in the last few quarters – however, inflation continues to rise.

This is a major source of concern for the global economy as commodity rates are rising at the quickest levels in decades. Climate change, labour shortages, COVID-19-induced supply-chain disruptions, and the Ukraine-Russia crisis are all to blame.

Raising interest rates – as witnessed in recent times – compromises growth in order to contain inflation, but if that strategy fails, there are no other sustainable alternatives. 

This will result in a plunge in economic growth and a rise in inflation.

In 2022, the global economy was forecast to rise by 4.5 per cent, but inflation has cut it short to 3 per cent. Average global inflation is estimated to hit 9 per cent. So, this brings us to our original question: “To what extent does raising the interest rate reduce inflation?”

What is Inflation?

Inflation does not mean that the prices of commodities are increasing or decreasing at the same rate. It is the year-on-year (y-o-y) percentage change in the value of the Wholesale Price Index.

It essentially assesses the change in prices of a basket of goods and services over the course of a year. The basket of goods and services varies over time as consumer tastes and trends change, but there are some items that are always included because they are necessary, ranging from meat and poultry costs to the cost of home insurance.

Causes of Inflation

There are two forms of inflation: “cost-push inflation” and “demand-pull inflation”.

Each inflation is caused by a unique source and has distinct short-term but similar long-term consequences. A decline in aggregate supply, such as supply chain disruptions or conflict; a fall in productivity; an increase in taxation or reduced subsidies; and higher wages all boost the cost of production and require enterprises to raise their prices to preserve profit margins. This is known as “cost-push inflation.”  

A country may suffer “demand-pull inflation” as a result of increasing aggregate demand. It is often the result of a thriving economy, which leads to increased employment. Aggregate demand is primarily boosted by four components: higher consumption as higher income leads to increased spending, increased government expenditure, increased net exports, and increased investment. Any of these could increase aggregate demand and push overall economic price levels.

Factors that exacerbated recent inflation

Shortages in the supply chain: The global supply chain relies on the efficient flow of containers – particularly from mega-ports such as ones operating in China – transporting raw materials and completed goods back and forth.

As COVID-19 hit the Mainland, these containers ceased to move, and when demand suddenly increased, there were not enough of them at sites where they were required. Demand for commodities outstrips supply, so firms quickly stockpile items.

The rest of the globe was affected as a result of this. In an interview with an India-based magazine, The Week, Nitin Arora – the Managing Director of MEO International Logistics – was quoted as having said that it would take anywhere between “15 to 18 to get a container from China to Mumbai” prior to pandemic-induced disruptions in the supply chain.

“Today,” he said, “it might take up to 50 days.”

This graph depicts the rise in container freight pricing from 2019 to May 2022. Container prices have risen dramatically in the previous two years. Freight expenses increased in 2021, reaching an all-time high of US$10,361 in September.

The COVID-19 pandemic caused massive disruptions, suspending or reducing the efficiency of whole enterprises and supply networks. Dock closures, dock traffic congestion, labour shortages, and a lack of modern shipping containers made the industry fragile.

In May 2022, the global freight rate index was US$7,645, a considerable decrease from 2021. The COVID-19 pandemic had a greater impact on container freight rates than the rise in fuel prices.

In general, fuel expenses are becoming less polarising in shipping prices, since container ship fuel consumption has declined by nearly 80 per cent, as per Transport Intelligence, when assessed in terms of fuel consumed per container.

This is owing to bigger container boats’ higher energy. Fuel prices will have to climb far more, severely to compensate for the impacts of a diminishing or increasing supply and demand balance, which will have substantial macroeconomic implications, lowering spending levels.

Inflation raises raw material prices: when suppliers raise prices to ration dwindling resources. These cost increases may manifest as expedited fees, surcharges, “shrinkflation”, or renegotiations. Hoarding of scarce products frequently results in higher inventory costs.

This graph depicts the rise in food, beverage, and raw material prices. Food costs are expected to rise by nearly 20 per cent this year before levelling off in 2023.

Milk and other dairy products have also seen price increases this year, with Coca-Cola and PepsiCo both raising prices due to supply-chain and labour shortages. As a result of the ongoing conflict between Ukraine and Russia, the global wheat and maize markets are expected to contract further in 2022-23.

Ukraine is the world’s fifth-largest wheat exporter, fourth-largest maize exporter, and top sunflower oil exporter. Food prices have risen because wheat-producing countries have prohibited wheat, maize, and soya bean exports since the beginning of the Ukraine conflict.

Kosovo, India, and Egypt are examples of such countries. Because hungry voters can be unforgiving, and no government wants to jeopardise their Roth, the priority of these countries’ governments is to now to control prices at home to ensure food security.

As inflation rises, trade policies inevitably become more protectionist. Diplomacy sometimes takes a back seat as the domestic market takes precedence. Inflation forces a diplomatic shift.

Wheat also requires two types of fertilizers: phosphorus and nitrogen. However, since Russia supplied the fertilizers, many countries now have limited access to them. The cost of wheat has risen. Maize supplies are also projected to tighten as supplies from Ukraine and the United States decline. However, global rice and soybean supplies are predicted to improve in 2022-23, increasing by 0.6 and 3.5 per cents, respectively, from 2021-22, as per a World Bank report.

Employees become more price sensitive: when unemployment declines and expenditures grow due to high employee turnover and labour shortages. Working parents, for example, may decide that they do not generate enough income to pay for preschool and quit their jobs, causing labour shortages to worsen.

As the cost of living continues to climb, businesses find employees less eager to labour for lower wages. Raising pay for some people, such as doctors, pilots, and lawyers, whose demand is constantly high and supply is low, would result in a lobby for compensation increases in step with inflation, resulting in a ‘wage-price spiral’.

Rise in oil prices and inflation rate

Crude oil is critical to a country’s industrial base growth as well as its domestic consumption. As a country with the second largest population and the third largest oil consumer, India’s demand for oil and concurrent consumption are skyrocketing.

The economic situation in India is deteriorating with each passing day of the Russia-Ukraine conflict. As India’s crude oil import costs rise, pessimistic projections are becoming more widespread. Rising crude oil prices, according to Edelweiss Wealth Research, will worsen India’s trade and current account imbalances. The expansion of the two deficits will pound the Indian rupee even more.

Worryingly for the economy, higher oil costs will form the basis for rising commodity prices. This is due to the fact that gasoline prices have a substantial impact on retail and wholesale inflation.

Crude oil price increases will force India’s inflation indices to rise. The Indian government can only endure inflation for far too long before having to interfere fiscally by lowering petrol prices and increasing food and fertiliser subsidies. The Indian government expects the conflict to just be the effectiveness of the control; otherwise, reduced tariff income and increased social expenditure may upset the government’s budget estimates, forcing it to depend on borrowed money.

Rising oil prices & inflation for oil-producing countries

This graph depicts Oman’s inflation rate from 1987 until 2027. In 2008, Oman experienced its highest inflation rate ever, reaching 12.56 per cent. Consumer spending and confidence were low as prices grew dramatically.

Oman, too, underwent a brief period of deflation, with prices falling and the unemployment rate rising. However, the economy of Oman has rebounded in recent years, and inflation has returned to healthy and moderate ranges but never at such high levels as in 2008.

With the exception of imported food, the overall consumer price index has not fluctuated as much as in other nations since the Omani government currently subsidises fuel and some utility expenses (electricity and water). Rental costs in the Sultanate are also lower than its GCC neighbours, limiting large price spikes and cost-push inflation.

As a result, Oman has been able to maintain a healthy inflation rate of 3.7 per cent. Expansionary fiscal and monetary measures were employed to get the economy moving. It shows that consumer spending and corporate confidence are high.

Net exports have grown, and the economy has been continuously flourishing. The forecast for the Oman economy is positive, with inflation estimated at 1.9 per cent, which is close to the ideal inflation rate of 2 per cent that every country strives for.

When compared with other nations’ inflation rates, such as the United Kingdom and the United States, Oman’s economy performs much better, maintaining a healthy inflation rate and strong public revenues in 2022.

This stems from a boom in oil demand and an average futures rate of US$112.93 for trading in the Dubai Mercantile Exchange in September 2022. 

How inflation affects the consumers, governments and businesses.

High inflation will always be a looming concern. As the inflation rate rises, people are more susceptible to hoarding products and making emotional financial decisions, which can push up prices further. It has had a detrimental influence on consumers, corporations, and governments worldwide.

High inflation affects consumers the most since they must manage a household with limited purchasing power. It is often assumed that if prices continue to climb, people will either stop purchasing or limit their purchases.

As a result, overall demand will fall and currency rates will be exacerbated by inflationary pressures. Inflationary pressures imply that the currency is losing value, and if the central bank does not raise interest rates rapidly enough, investors will progressively withdraw owing to reduced returns. Finally, it contributes to even greater inflation.

Governments are also severely impacted by inflation. It’s common to refer to inflation as the “mother of political transformation.” Inflation has been exacerbated by the war, there are protests everywhere, and protesters can be obnoxious near voting booths. Former US President Jimmy Carter was brought down by inflation, rising unemployment, and skyrocketing food and energy costs during his administration.

Ronald Reagan ousted him for reelection. Food costs in the US have increased by 10 per cent, and fuel costs have increased by 8 per cent. Inflation may decide the election when President Joe Biden faces midterm elections in November.

It has the potential to alter the direction of American politics. Leaders understand the connection between inflation and elections. Inflation was seen as one of the main causes of the Manmohan Singh administration’s defeat in the 2014 parliamentary elections in India.

In addition, Sri Lankan Prime Minister Ranil Wickremesinghe’s resignation from parliament can be attributed partly to inflation. Food costs have increased by at least 7 per cent, and worldwide inflation is currently over 7 per cent.

Elections will prevail in some 50 nations through 2022 and 2023, including the likes of Brazil, Israel, Pakistan, Bangladesh, and Turkey. And as these governments face stiff targets in the form of inflation and rising prices, current leaders could soon find themselves out of jobs. Inflation, undeniably, alters a nation’s course.

Inflation has an impact on businesses as well. Inflation typically begins with scarcity or an increase in demand for a product, which causes businesses to raise their prices and total spending on commodities. This price rise kicks off a cycle of rising expenses, making it increasingly difficult for firms to maintain their margins and profitability over time.

The impact of inflation on GDP and stock market performance

Food and gasoline are the two primary drivers of inflation in India, and prices for most food products have risen in recent months as a result of supply shortages caused by Russia’s conflict with Ukraine, irregular weather patterns in Europe, and export restrictions.

Rising prices have previously caused socio-political turmoil, something the Modi administration is attempting to avert. Inflation has been a problem for the world’s seventh largest and second-most populous economy. As per a Fitch Ratings report, the Reserve Bank of India (RBI) is expected to boost interest rates to 5.9 per cent by December 2022, citing a worsening inflation forecast.

The prognosis for India’s economic growth, as per Morgan Stanley’s analysis, for the next two financial years cites a worldwide crisis, inflationary pressures, and sluggish domestic consumption as factors influencing Asia’s third-largest economy.

For stock market investors, annual GDP growth is crucial. Most firms will be unable to increase profits if the overall economic activity falls or remains flat. The rupee is under pressure as a result of soaring US inflation, rate hike worries, and a stock market decline.

More rate rises by the US Fed may result in larger outflows by foreign portfolio investors (FPIs), who have already transferred Rs 22,978 crores out of the stock markets in June, as per analysts quoted by Indian Express.

The Indian market is only expected to stabilise when the US market stabilises and the US Fed stops raising interest rates. When FPIs return and begin injecting money again, the market will recover.

Excessive GDP growth, on the other hand, is problematic since it will almost certainly be followed by an increase in inflation, which would reduce stock market profits by making currencies less valuable. Most economists think that 2.5–3.5 per cent GDP growth per year is the most that the economy can sustain without creating negative consequences.

A rise in GDP reduces the country’s unemployment rate. Unfortunately, low unemployment rates have been shown to be more expensive than beneficial because, as aggregate demand for goods and services grows faster than supply, prices rise, leading to inflation. 

What actions do governments take?

Contractionary fiscal or monetary policy is used by governments to fight demand-pull inflation. Monetary policy, with an emphasis on interest rates, is the principal strategy used to reduce demand-pull inflation in many nations like the United States and India.

As a result, many Central Banks are assigned an inflation target and told to employ interest rate increases to accomplish it. If inflation exceeds the apex bank’s target range, the interest rate will be raised. The tightening of monetary policy will lower demand-pull inflation. This will discourage borrowing for large purchases and encourage saving and attract “hot” money, perhaps increasing the external value of the floating exchange rate.

A policy to correct cost-push inflation in the short term is to instruct governments to raise their exchange rate. When a currency appreciates, exports will be more expensive than imports. Because import costs have been lower, raw material capital has been reduced, forcing domestic enterprises to find a means to cut their prices, resulting in a reduced rate of inflation.

In the long run, the government will implement supply-side measures such as increasing expenditure on worker training and education, which will increase company productivity and efficiency. Productivity growth will result in lower labour costs.

Lower corporate taxes will encourage businesses to purchase more efficient capital equipment, putting downward pressure on prices. Other supply-side measures are privatisation, deregulation, subsidies, reduced income tax, and increasing spending on infrastructure.

Ideal inflation & interest rate

The Central Bank’s aim is to keep inflation low and achieve sustained economic growth. Lower single-digit Inflation rates are typically regarded as reasonable and good for the economy, whereas higher inflation rates indicate a risky zone that might lead the currency to depreciate.

Unsustainable GDP growth drives up costs and leads to inflation, which in turn has the propensity to lead to hyperinflation when not addressed. Trends point to cash squandering since people anticipate that their currency will lose value in the future.

This promotes greater short-term GDP growth, which leads to even more price increases in an inflationary environment.

Increasing interest rates will reduce inflation, as it drains liquidity from the market.

And while this would result in more people maintaining deposits instead of spending, it would make borrowing expensive for consumers, further leading to a delay in scalable projects and risky investments. 

As a result, demand will be reduced, and prices will presumably remain stable.

But as we learn today, raising the interest rates in countries such as the United States and the United Kingdom have not led to a significant decline in inflation rates. It must be noted that interest rates became even more aggressive in June following a 0.75 per cent increase – the highest rise since 1994.

Supply chain disruption is also one of the leading drivers of price rises. As long as this remains an issue, we would expect a “wage-price spiral,” which will drive up inflation.

Raising interest rates too rapidly hurts demand and stagnates economies. If firms cease to recruit or even lay off workers, it may lead to rising unemployment. And, if authorities overreach on rate increments, the economy might enter a recession, stalling and undoing its recent growth. Raising interest rates can thereby cut inflation, but it comes at a cost.