To all the entrepreneurs, business managers and small company investors in the UK, I need your help with an important question. Have higher interest rates had an impact on how much work gets done around the UK?
I mean, are companies producing more, and are new companies being founded to produce something, now that it costs more to borrow money?
Or have higher interest rates impeded production, caused companies to go bust, halted expansion plans and cut investments in new production?
Let me know what your experience has been, with your permission to republish comments anonymously: [email protected].
You see, I suspect that central bankers have made a high school-level mistake in their understanding of economics. They’ve forgotten about half the equation which determines prices and thereby inflation.
So, let me ask the question in a way they might understand. What effect do higher interest rates have on the supply side of the economy?
I haven’t seen the question, let alone the answer, mentioned anywhere. Everyone just focuses on the demand side of the equation when they discuss monetary policy.
The theory they refer to goes like this…
Central bankers, in their infinite wisdom, manage the economy by mucking about with interest rates.
When the economy is stuttering, causing a lack of inflation, they cut interest rates to stimulate demand. This causes economic activity and inflation as buyers bid up prices with cheaply borrowed money.
When the economy is running too hot, causing inflation, central bankers raise interest rates to cut demand and thereby allow prices to cool.
Central bankers would describe this as “shifts in the demand curve”. And they’d call it “aggregate demand” meaning “general” or “overall” demand.
But the economy has two sides to it. It’s not just demand. There’s also supply. And it’s wherever the twain shall meet that sets the price, thereby also determining inflation.
You can’t just conduct monetary policy focusing only on the demand curve. Because that’s only half the equation.
And yet, that seems to be the presumption of how monetary policy is conducted today.
Don’t believe me?
Do a quick search on “how monetary policy affects aggregate supply” and your results will be…
“Policymakers can influence aggregate demand with monetary policy,” “Fiscal policy affects aggregate demand,” “Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand,” and so on and so forth…
It’s all “aggregate demand” and no “aggregate supply”.
Just as Milton Friedman simply presumed velocity of money to be stable, thereby making the quantity of money the determinant of inflation, central bankers seem to have assumed the supply side of the economy to be fixed. As though fiddling with interest rates doesn’t impact businesses.
But I’ll bet it does…
My own theory is that interest rates matter a great deal to the supply curve too. That is because businesses tend to borrow money. And higher interest rates make borrowing money more expensive. Which suggests that producers will do less of it. That in turn means that there will be less production.
In fact, the interest rate is a key determinant in how much companies invest in new production facilities, and how many companies are formed to make such investments. The cost of borrowing is an important part of what’s called their cost of capital.
A low cost of capital makes lots of projects viable. A higher cost of capital means that less projects look like they’ll be profitable.
Investments in new machinery and plants which make sense at 0% interest rates no longer make sense at 3% because the costs are higher. Thus, higher rates cut supply in the economy.
What makes this interesting is what happens you combine the ignored supply story with what happens to aggregate demand. In other words, what conclusions you reach when you consider both sides of the equation.
Raising interest rates cuts both supply and demand. It shifts the supply curve and the demand curve to the left, in economics speak. This leaves us with the same price level (no inflation), but less stuff produced and consumed.
That’s an oversimplification, because it all depends on the shape of supply and demand curves, as well as the magnitude of the shifts. I haven’t got a clue about what either of those might look like in reality. So… it’s more correct to say that the effect on inflation is ambiguous, but the effect on GDP is unambiguously bad. That’s why we’re having the recession that we’re having, in other words.
If central bankers considered this, their claims that higher interest rates would bring down inflation could be undermined. They’d just be doing damage to the economy without a clear outcome on inflation…
Now I reckon that during a supply chain crisis and in the aftermath of lockdowns, with business struggling badly, the impact of higher rates on aggregate supply is likely to be bigger than the impact on aggregate demand.
Put another way, businesses will be hit worse than consumers.
This means that central banks raising rates are fuelling inflation and cutting GDP – the precise opposite outcome wanted by central banks from their higher interest rates…
Whether you agree or disagree with that analysis, it’s quite clear to me that central bankers seem to be ignoring some fairly crucial impacts of their tighter monetary policy. Ironically, those impacts are on supply, which also triggered the inflation that so surprised central bankers in 2021.
It’s also worth mentioning that interest rate hiking cycles tend to end with some sort of crisis as someone goes bust. That’s precisely what you’d expect if you’re accusing central bankers of paying attention to demand (consumers) and not supply (businesses).
It’s easy to use words like “aggregate supply” isn’t it? Rather than explaining what this really means. Businesses going broke, taking lifelong savings and efforts with them, as well as the jobs they supported.
I can’t imagine what it must be like to have a business that fell prey to higher interest rates. And then to be told that his will slay inflation when it clearly causes shortages of the goods which used to be produced and thereby higher prices, not lower
Only an economist would think of harming the UK’s productive capacity to bring down inflation. And then wonder why companies go bust…
Editor, Fortune & Freedom