Interest Rate vs Inflation

Seems everyone is (including decision makers at central banks) paying a lot of attention on using interest rates to tackle the ever-increasing inflation (US's inflation in May 2022 was 8.6% - the highest in 40 years). However, I would like to think this round of rate hike by global central banks may not be able to achieve their goals given the following reasons:

According to history, most rate hikes had been preventive measures (i.e. prevent economy and stock market from overheating). I could still remember vividly when I was a high school student I read a comment from Milton Friedman that increasing interest rates are mostly accompanied by bull markets. The current rate hike is used to fight against inflation and apparently the causes of the most severe inflation rate over the past 40 years are not only because of (i) central banks printing money over the past two years, but also (ii) disruption of the global supply chain (COVID and the war in Europe). Central banks can certainly reduce money supply by increasing interest rates, but they have close to zero capability in affecting the global supply chain.

People are so used to ultra low interest rates over the past 15 years and this round of aggressive rate hike will drastically (to say the least) affect asset allocations of all investors and apparently one of the safest available investments today is US dollar. For countries other than the US, we are encountering situations that we have never experienced before (sell-offs in both equity and debt markets). Poor economies (because of COVID as well as supply chain disruption) and poor financial markets means everybody in the society are worse off and hence this would lead to further reduction in spending (on both OPEX and CAPEX). Once this downward spiral happens, stagflation will be inevitable.

When we study history, we could see that high inflation together with declining economies created the perfect recipe for social unrest. In order to contain potential social unrest and prevent money from leaving the country, drastic measures had been employed by governments to prohibit citizens from withdrawing money from banks and transferring money to other jurisdictions. Of course, unless these countries had very effective measures to control their citizens, such iron fist policies had pretty much guaranteed even more social unrest in their respective countries.

In order to solve the current problem, increasing interest rate alone will be absolutely insufficient (not to mention increasing interest rate in declining economy is pretty much unheard of in recent history). I would like to image, major global powers will be very much inclined to use political/diplomatic measures to solve the supply chain problem with the aim to curb the inflation and its negative impacts. However, the complexity of political negotiations as well as the current unfavorable geo-political situation would not be helpful in concluding actionable international collaboration that would be beneficial to most stakeholders.

My next article will discuss my observations on what investors are doing with the aim to generate positive alpha in this turbulent times.