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Interest rates' awkward facts

Higher interest rates reduce inflation only by raising unemployment. But by how much they reduce inflation is unknown.
Interest rates' awkward facts

Interest rates are likely to rise this year. The Bank of England could raise them for a second time next month, and the Fed is expected to follow in March. This raises three unpleasant truths.

First, higher interest rates cut inflation by inflicting pain. In raising the cost of credit they reduce not just consumer spending but companies’ demand for labour. “Monetary policy tightenings raise unemployment” concluded the Bank of England’s Gregory Thwaites and colleagues in one study of their effects. In 1989 then Chancellor John Major said of high interest rates “if the policy isn't hurting, it isn't working.” That was good economics, if too honest.

Secondly, the hurt can be global and fall upon the most vulnerable. One channel through which higher rates reduce inflation is by raising the exchange rate, thereby cutting import prices. A stronger dollar, however, is nasty for many emerging markets. It raises the cost of servicing dollar-denominated debts, and also the local-currency cost of those raw materials that are priced in dollars. It’s sometimes said that ultra-low interest rates benefit the rich by supporting asset prices. That’s only part of the story. They also help low-wage workers in poor countries. Higher rates withdraw such help.

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