Raising interest rates won’t solve inflation. Here’s why.

On June 1, the Bank of Canada is expected to increase interest rates again, from 1.0% to 1.5%. Progressive economists argue that this won’t address the root causes behind current inflationary pressures and may harm our economy. There’s much more that governments could be doing to better address rising prices and avoid the pain of rising interest rates.

What’s causing inflation?

In the 1970s, economists believed that inflation was caused by too much money floating around in the economy. They thought the only way to lower inflation was to keep the amount of money in the economy relatively constant. This approach is called monetarism. Even though monetarism was largely unsuccessful in combatting inflation, it has stuck around as a zombie idea that refuses to die.

Conservative populists still say the Bank of Canada is causing inflation by printing too much money. But the truth is that most money is created when private banks lend money to individuals and businesses. Either way, money creation isn’t inflationary in and of itself. Other factors in the real economy play a bigger role.

More money in the economy isn’t a problem as long as supply can keep up with demand. For example, if there are enough workers and materials to make to a certain product, it will be straightforward to expand production by adding another shift in an existing facility. But if there is a shortage of workers or the supplies required to expand production, we might see longer term shortages that result in price increases for that product.

While most analyses of inflation concentrate on demand, current inflation is being driven by supply shortages and profiteering. Let’s look at a few examples.

Inflation happens when demand for goods surpasses the supply of goods. Sometimes, this can be caused by unforeseen factors that suddenly reduce our economy’s ability to supply goods. This happened during the pandemic, when lockdowns caused shortages throughout global supply chains. Similarly, the Russian invasion of Ukraine has affected the availability and price of grain, fertilizers, and fossil fuels.

Inflation can also be spurred by a combination of demand growth and supply challenges. For example, increasing demand and problems in the supply chain have resulted in an ongoing shortage of semiconductor chips. This has had a ripple effect by reducing the number of new vehicles that get made. With fewer new vehicles being produced, the price people are willing to pay for a second-hand vehicle has increased dramatically. Unfortunately, the semiconductor shortage, and the inflationary pressures it is creating, will not be solved quickly. There are very few semiconductor producers. In fact, only two companies produce 70% of the global supply. Setting up new production is expensive, requires highly skilled workers, and takes months or years to complete.

Today’s inflation is also being caused by profiteering. Canadians for Tax Fairness studied financial information from publicly traded companies in Canada[1], and found that between 2019 and 2021, their average annual sales revenue increased by $174.5 million – but their costs only increased by $16.9 million. That means that 90% of the increase in revenue in 2021 was from higher profit margins. Lack of regulation, competition, and low corporate tax rates make profiteering worthwhile for corporations.

Even though current inflation is being caused by supply issues and profiteering, central banks are still attempting to address inflation by reducing demand. In other words, central banks want to solve inflation by reducing the amount of money in people’s pockets. Because the central banks can’t take money away from people directly, they do it by making it more expensive to borrow money. When interest rates are raised, there are fewer borrowers. As a result, private banks create less money. The theory is that when less money is circulated, there is less investment in the economy and unemployment increases. Ideally, this reduces people’s purchasing power and slows the rate of price increases.

The problem is that changing prices by changing interest rates is a bit like steering a cruise ship with a canoe paddle. The Bank of Canada expects it to take two years before they fully see the impact of their actions on the economy. In the past, the Bank has increased interest rates higher and faster to prove that they were committed to reducing prices. This is because the only immediate impact of their actions is on people’s expectations. As such, central banks have had a tendency to go too far and cause a great deal of hardship for workers.

How do governments respond to inflation?

The current economic consensus assumes that only central banks can address inflation, and governments should stay out of their way. It is because of this understanding that governments often respond to inflation and interest rate increases with austerity. Governments are generally hesitant to spend more money when the Bank of Canada is increasing interest rates, because it is counterproductive to be adding more money to the economy when the Bank of Canada is trying to reduce the money supply.

At the same time, government revenues often improve significantly during periods of inflation. Their revenue is a proportion of economic activity. As prices rise, so does government revenue. While revenues increased for provincial governments in 2021, and will again in 2022, many are still underinvesting in public services and capping wage increases between 1 and 2 per cent.

What can governments do?

There is a great deal that fiscal policy can accomplish in the face of inflation. In the short term, it is important to understand the causes behind inflation, and try to understand what can and cannot be fixed. For example, governments should be helping to repair supply chains and transportation networks in the short term, and thinking about how to make our industrial policy resilient to future challenges in the long term.

In times of inflation, governments can think about how to provide public alternatives for high priced items. For example, if gas prices are going to be high in the long term, governments at all levels should think about how to make it easier and cheaper to get around without needing fossil fuels. This is a more targeted and equitable way of reducing demand for a high priced good than the central bank model of reducing the money supply.

Governments can also regulate prices. Rent control is a good example of this. Wherever possible, policy makers should think about how to maintain the supply of goods that are price controlled. In the case of rent control, a solid plan for public investment in non-market and co-op housing would help ensure there was sufficient supply of affordable rental housing.

Public services also play a big role in making life more affordable for everyone. Government spending on everything from childcare and healthcare to public transit and recreation makes life more affordable for people, and makes us all less vulnerable to periods of inflation or economic downturns.

This spending does not have to be funded with borrowing. If policy makers are worried about stimulus spending increasing interest rates, they can fund this spending with the revenue increases they inevitably receive during periods of high inflation. In addition, governments across Canada have cut taxes for corporations and the wealthy over the past 30 years. This means that there is significant room to increase these taxes. Spending that is not funded by borrowing will not be considered inflationary by the central banks, and so won’t prompt them to raise interest rates further.  Increasing corporate tax rates and taxes on wealth will also counteract the negative impacts of increasing wealth concentration and inequality.