Why does a sharp increase in interest rates take precedence over any other policy in countries with high inflation?
Why does a sharp increase in interest rates take precedence over any other policy in countries with high inflation?
Peyman Molavi Economist | Wealth Manager
In economics, no variable can disrupt the basis of economic decision-making as much as inflation. When the inflation rate remains at high levels for a long time, it is not only a matter of increasing prices; the main function of money is also disrupted. Money, which should play the role of a store of value, a unit of measurement, and a medium of exchange, gradually loses the trust of society. In such circumstances, individuals and firms no longer make their decisions based on productivity or real returns, but rather try to maintain their purchasing power by fleeing money. This change in behavior itself becomes a new engine for intensifying inflation.
For this reason, in economies suffering from chronic inflation, the first task of the central bank is not to stimulate economic growth or reduce the unemployment rate, but to restore confidence in the national currency. The historical experience of countries ranging from the United States under Paul Volcker to Brazil, Israel, Poland, Turkey, and even Argentina shows that almost no other economic reform has achieved the desired results without stabilizing the value of the currency.
The main tool that central banks use to achieve this goal is to raise interest rates. Many think of interest rates as simply the cost of borrowing, when in fact the interest rate is the most important price in any economy; the price that determines the value of consumption today versus future consumption and signals to society how valuable it is to hold money. When inflation is higher than the interest rate, the real interest rate becomes negative, which means that anyone who keeps their money in cash or in bank deposits will lose some of their purchasing power each year.
In such an environment, economic behavior is quite predictable. Instead of saving, households buy assets such as gold, foreign exchange, housing, or durable goods. Firms also shift their resources from productive investment to activities that benefit solely from inflation. The result of this behavior is an increase in the velocity of money, a growth in speculative demand, a decrease in productive investment, and ultimately a further escalation of inflation. In other words, a negative real interest rate is not only a consequence of inflation, but also one of the main factors in its persistence.
Therefore, the policy of increasing interest rates is an attempt to correct economic incentives before it is a tool for reducing demand. When the real interest rate becomes positive, holding money makes sense again. The demand for immediate conversion of money into assets decreases, inflation expectations gradually adjust, and the central bank sends the message to economic actors that controlling inflation is a policy priority. This is the point from which many successful economic stabilization programs have begun.
Critics of raising interest rates often argue that such a policy could lead to economic stagnation, reduced investment, and increased unemployment. This criticism is correct in the short run; but the fundamental question is what is the cost of not raising interest rates? The experience of countries that have maintained negative real interest rates for years shows that the end result has been chronic inflation, capital flight, reduced long-term investment, increased inequality, the spread of unproductive activities, and ultimately reduced economic growth. In other words, the economy is forced to choose between “short-term stagnation” and “permanent instability.”
That is why almost all successful programs to contain inflation, from Paul Volcker’s policies in the United States to the stabilization program in Brazil and the monetary reforms of Eastern European countries after the collapse of the Soviet Union, began with a common action: raising interest rates to a level where the real interest rate becomes positive. Only then have financial reforms, economic liberalization, privatization, and the attraction of foreign investment been able to show their lasting effects.
Therefore, in economies plagued by high inflation, raising interest rates is not an ideological choice but an economic necessity. As long as holding money is unprofitable, no amount of structural reform will be able to change the economic behavior of society. Restoring confidence in the national currency is the first step on the path to restoring stability, growth, and investment, and this goal will not be achievable in practice without a positive real interest rate.
