Interest rates and greenflation

Mahmoud Mohieldin
Monday 14 Feb 2022

There is now no longer any doubt that the recent wave of inflation worldwide is here to stay, putting additional pressures on the world’s central banks, writes Mahmoud Mohieldin

The data is in and have settled the dispute between two camps of economists and central banks over whether the post-Covid-19 pandemic price hikes that have taken place worldwide reflect temporary or lasting inflation.

There is no longer any doubt that the latter is the case and that the major central banks, including the US Federal Reserve, were late in taking precautionary measures. This realisation has shaken the confidence of the markets in the banks’ performance, and the repercussions of this will continue for some time. The economy has no tolerance for advocates of the “art of doing nothing.” This applies above all in times of crisis, when “doing everything possible” is a decision-makers’ duty.

Slow decision-taking comes at a high cost. It causes inflation to drag on longer than it would otherwise have done if action had been taken sooner to dial back monetary easing and then raising interest rates. The situation could get worse if central banks are forced to raise interest rates at faster and higher rates if the markets do not respond as they expect. This would be like a driver who, realising too late that he should have slowed down, then has to slam on the brakes. 

One frequently asked question about interest rates is twofold: how high will they increase and how long will they last? In the light of recent remarks by Federal Reserve chair Jerome Powell, investors expect a succession of rate hikes throughout this year and the next, each by 25 basis points, raising the benchmark rate from its current zero to 0.25 per cent to 1.75 to two per cent by 2024. 

As justification for the hikes, Powell pointed to the seven per cent rise in the consumer price index in the US, which is higher than the global inflation rate of six per cent. A five per cent increase in wages in the US has bolstered the inflationary wave and expectations, according to the UK magazine the Economist, which reported that when Americans were asked about their inflation expectations, they said it would average six per cent over the next 12 months. This kind of inflation necessitates multiple hikes in the interest rate, as mentioned above. 

However, work also needs to be done to restore confidence in the decisions of the Federal Reserve. Raising interest rates alone is not enough to bring inflation and inflationary expectations under control. There are also limits to how high the Federal Reserve can raise interest rates without undermining the economic recovery, especially as they affect investment, growth, and employment.

There is also the problem of mounting public, private, and domestic debt. This has been mounting dangerously in the fourth debt wave that it is hoped will not end in crisis like its three predecessors, the last of which was the global financial crisis in 2008. 

Economic mismanagement of the responses to climate change has caused what has been termed “green inflation.” Instead of adhering to a safe, fair, and efficient transition to clean energy to reduce emissions harmful to the environment and the climate, decision-makers have succumbed to a frenzy of ad hoc withdrawal measures from investing in traditional energy sources and a headlong rush into alternative renewable energy sources. 

The result has been soaring energy prices and a sharp increase in their contribution to inflation. This is before factoring in the detrimental impacts of geopolitical tensions on energy prices. It is important to understand that switching to an alternative energy system will be costly and have an impact on prices. 

The following points will help make this clear:

- It is scientifically correct to say that the world should reduce harmful emissions by 7.6 per cent annually until 2030 in order to comply with the commitments of the 2015 Paris Agreement on Climate Change. But this will not be easy. Even with the sudden halt in activity following the onset of the Covid-19 pandemic in 2020, the global rate of increase in harmful emissions did not fall below six per cent;

- It is impossible to ignore the potential inflationary impacts of high carbon pricing. The economists Vitor Gaspar and Ian Parry suggest acceleration of carbon pricing by bringing it up to at least $75 per ton by 2030. This is all the more the case when we bear in mind that four-fifths of harmful emissions are unpriced and those that are do not exceed $3 on average globally; 

- The proposed measures to reduce emissions also include carbon pricing within the framework of the emissions-trading system, as is the case in Europe where the price had reached €90 per ton by the end of 2012. This was three times its price at the beginning of the year, according to the German economist Isabelle Schnabel, a member of the executive board of the European Central Bank, in a speech at the American Finance Association earlier this year.

It is essential to anticipate the inflationary effects of the bundle of measures that have raised, and will continue to raise the cost of obtaining an energy mix from conventional sources before applying the measures, plus the rising costs of alternative energy components as occurred last year in the lithium, graphite, cobalt and manganese markets, plus the proposed carbon-pricing measures in the production, trade, and usage stages. 

The impact of these changes should not be underestimated, as has been the custom in the standard prediction models used by the world’s central banks, which have tended to regard changes in energy prices as supply side incidentals that will subside after a while.

Take rising fuel prices, for example, since these have become a significant component in the rise in the consumer price index in Europe in the last quarter of 2021. Add to this the steps that fiscal policies and social security systems should now include in order to support the poorest segments of society from these rising prices. 

Even in the world’s wealthiest economies, the poor are suffering from high energy prices. According to Schnabel, eight per cent of the population of the EU, or around 36 million people, have said that they cannot afford to keep their homes adequately warm. 

The vital measures needed to fight climate change must be set within a framework for the sound management of the transition to carbon neutrality. This means dealing with the effects of these measures on prices, especially in the light of current global inflation rates. 

Once again, we need to stress how important it is to implement climate-change mitigation measures as a main and inseparable component of achieving sustainable development goals in order to limit detrimental impacts on the poor, greater income disparities, and fewer job opportunities.

The repercussions of behaviour after the pandemic confirms once again the dangers of an “island unto itself” approach to decision-making. Not only is this heedless of the welfare of peoples on the other islands, but it also fails to appreciate that decisions taken in one place affect others and that conflicting decisions jeopardise everyone. 

Some realise that continuing to ignore the need for cooperation and coordination is a source of danger to themselves. Others will not appreciate this advice until it is too late.

* An Arabic version of this article appeared on Wednesday in Asharq Al-Awsat.

*A version of this article appears in print in the 10 February, 2022 edition of Al-Ahram Weekly.

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