What is unnatural inflation

Interest rate control harbors inflationary explosives

Interest rate control policies exacerbate the debt problem and could become a serious inflation problem. This is because governments are de facto responsible for the purchasing power of money.

Probably no other economic phenomenon is discussed as controversially as interest. He's something of a bone of contention among economists. Some economists believe that the “correct” interest rate could fall to zero percent or even become negative. Others deny this and see zero or even negative interest rates as literally “unnatural”. They fear major economic damage - in the form of excessive debt, bad investments and inflationary speculative bubbles - if the central banks push interest rates to or even below zero.

Interest rate control policy

It is probably the power of the factual that is causing the world's major central banks to set interest rates at extremely low levels or even in the minus range: The global credit burden, which is receiving a huge boost in the wake of the Corona crisis, is becoming more and more overwhelming. The International Institute of Finance (IIF) estimates that global debt hit a record $ 281.5 trillion last year; that corresponded to 355 percent of the world's gross domestic product. So that the debt pyramid does not wobble, the central banks are reducing the cost of borrowing as much as possible.

To do this, they set their key interest rates to zero percent or - as in the euro area, Japan, Denmark and Switzerland - brought them below the zero line. In addition, many central banks are buying up debt securities on a large scale. As a result, they have a direct influence on the prices and thus also on the yields of the bonds. As a result, market returns are no longer freely generated, but are more or less dictated by the central banks. This type of monetary policy amounts to what is known as a "policy of interest rate control". It holds special explosives.

The central banks' purchases of debt securities result in lower market interest rates than if these purchases were not made. This, in turn, encourages debtors - above all the states - to take on even more debt. If more debt securities are offered, this tends to exert downward pressure on bond prices or upward pressure on interest rates - there is a negative relationship between the price of a bond and its interest rate. To prevent the undesirable rise in bond rates, the central bank must step in and buy debt securities.

Sovereignty over the money supply

In this way, the central bank can keep market interest rates low. However, it expands the money supply through its bond purchases. The central bank ultimately pays for the debt securities purchases with new money, literally created out of nowhere. And that means: If the central bank subscribes to a policy of interest rate control, then it gives up sovereignty over the money supply. How much new money it brings into circulation now depends on the state's appetite for credit, which is known to be insatiable. In technical jargon this is called “fiscal dominance”.

It doesn't bode well. For it amounts to a return to the conditions in the late 1960s and early 1970s, when many central banks were subdivisions of the finance ministries bound by instructions and had to finance the budget holes of the states with newly created money. The result was high inflation, sometimes even hyperinflation (as in many Latin American countries). But because the social costs of inflation became too great after all, people rethought.

The central banks were released into political independence, their monopoly on money should no longer be abused by day-to-day politics. In addition, the central banks were tasked with keeping inflation low. Initially with success. From the early 1980s, consumer goods price inflation was on the decline in many places. But two new problems arose.

Inflation returned in a new guise. The prices of inventory goods - stocks, houses, land, etc. - began to inflate sharply. Above all, however, the debt swelled enormously. The central banks - in close cooperation with the commercial banks - continued to expand the range of loans.

By issuing new loans, they have set in motion a sham boom that requires ever more credit, made available at ever lower lending rates, in order not to collapse. And that closes the circle: The world credit and money system needs interest rates that continue to fall in line with the trend.

Even if the central banks achieve just that with interest rate control and ensure calm on the credit markets, one should not give in to the hope that the debt problem that has accumulated can be silently and painlessly eliminated in this way. Rather, the policy of interest rate control runs the risk of adding a serious inflation problem to the debt problem by making governments de facto responsible for the purchasing power of money. And, as the history of currency shows, that was almost always detrimental to monetary value.

Thorsten Polleit is Chief Economist at Degussa Goldhandel GmbH in Frankfurt a. M.