We have heard and read a lot about central banks increasing interest rates in the face of inflationary episodes as a preventive policy or to contain existing inflation.
Why and how a hike in interest rates leads to a decline in inflation rate is a theoretical discussion that has a long history (perhaps more than 100 years); it has been discussed in detail in monetary economics.
This writing is not about theoretical, academic arguments. However, it is important to know that introducing the short-term interest rate in the money market is currently the most effective policy used by central banks to curtail inflation.
Empirical evidence shows that this method works and countries that have knowledge, expertise and the infrastructure to control interest rates do not struggle with high, chronic inflation.
Kamran Nadri, an economic expert, prefaced his article for the Persian economic daily Donya-e-Eqtesad with this note. A translation of the text follow:
Iran has registered high, chronic inflation for almost five decades and its policymakers have failed to control inflation whereas leading countries in economics have been able to effectively manage inflation by using interest rates.
An Evil Force Effectively Controllable by Economists!
The story of interest rate in Iran is boring and sad. In the 1980s, after years of theoretical debates, the world realized the importance of interest rate in the economy and how it controls economic fluctuations. At the same time, the idea that “interest is equal to usury” and that Iran’s economy needs to rid itself of this “demonic force” gained currency in Iran. It is clear that the natural and divine force of “price mechanisms”, including the interest rate that determines the price of the current source versus the future source, cannot be removed from the world, but flawed thinking and not knowing the difference between the concepts of interest and usury have kept our country behind for years on the monetary and financial fronts.
With this worldview, the Central Bank of Iran and other financial institutions have been left behind the so-called progress train; Iran’s economy has been suffering for decades from inflation, inefficient financing (in banks, money and capital market) and investment deviations. Since there is no correct intellectual and cognitive infrastructure about interest rate in Iran, the man on the street, businessmen and even some university graduates in Iran cannot digest how an evil force is so effective in the hands of economists.
As such, banks in Iran have always been under the suspicion of indulging in usury; the public and economic players believe that interest rate, even in high inflationary conditions, should not increase and that the solution to Iran’s economic problems is to even reduce the interest rate.
The current economic situation has exerted a hefty pressure on the interest rate to increase; it seems that maintaining the status quo is not possible for banks given the decrease in the duration of time money is kept in banks and the shift of long-term deposits to money.
Policymakers who thought that they could control inflation by maintaining the current interest rates (and perhaps reducing them) by creating a monetary base monitoring council and realized that they have no choice but to accept an increase in interest rates. Once again, the systems that oppose and deny natural forces have been subjected to the divine will of nature. However, how likely is the increase in interest rates in Iran? Are we in the midst of a fundamental transformation and change in monetary policymaking?
Containing Inflation Not the Main Goal of Monetary Policymaker
Sadly, there is no room for optimism. The reason for this pessimism is the very high inertia in the entire system and the strong desire it has to continue wrong strategies.
The first serious obstacle is the failure of the political system to accept the necessity of CBI’s independence, despite years of expert debate. A council whose composition symbolizes conflict of interest is in charge of making decisions regarding interest rate.
The Ministry of Industries, Mining and Trade opposes the interest rate hike under the pretext of supporting the industry. Other representatives of the government, including the Plan and Budget Organization and the Ministry of Economic Affairs and Finance, are worried about the increase in the interest rate of government bonds and the decrease in the value of stocks. The representatives of the private sector and the parliament, who have a consultative position in this council, are also unlikely to be in favor of raising the interest rate.
Therefore, inflation will be the first thing that will be ignored in the meetings of the council. In other words, inflation control is in conflict with the interests of most members of this council. Of course, there is a small possibility that in the current situation and with the insistence of the central bank, tactically, a slight increase in the interest rate will be agreed upon but with these members, controlling inflation through interest rate will not be the main strategy.
The bad news is that in the review of the central bank law, recently approved by the parliament and undergoing the final approval process in the State Expediency Council, inflation control has not been specified as the main goal of the monetary policymaker, nor have government representatives been removed from the policymaking council.
Therefore, it is unlikely that inflation control through interest rate increase will become the main monetary policy in Iran, at least not in the near future. So, in addition to the flawed attitude and grave cognitive weakness about the interest rate, which is the root cause of the problems in monetary and financing affairs, there is no decision-making infrastructure to employ interest rate as the main form of monetary policy in Iran.
Management Apparatus to Blame
Most of these obstacles are to blame on the management apparatus of the central regulator. Does the central bank have a specific rule in determining the interest rate? What is the central bank’s estimate of the equilibrium interest rate? What is the central bank’s perception of the production capacity of the economy? To what extent should the developments in markets such as forex market, stock market and housing market be taken into account when it comes to setting the interest rate?
The central bank is unlikely to have an answer to these questions. The disorderly state of banks should be taken into consideration as well. Does the central bank know what effect each 1% increase in interest rate has on the value of assets and the banks’ debts? Banks’ balance sheets are not in a favorable condition due to years of unprofessional decisions and misguided political interventions (including mandated interest rates and severe regulatory weakness); most banks are in a financial strait and suffer from lack of cash. Is there the necessary professional power to increase the interest rate and at the same time regulate and stabilize the state of banks? The answer seems to be negative.
In closing, although raising the interest rate based on successful global experiences is an effective solution to save the country from chronic inflation, the fundamental cognitive error, the lack of an efficient decision-making system and governance, years of unprofessional management and unprincipled interventions and the marginalization of experts in one of the main economic institutions of the country is unlikely to help cure this sickly economy.
It is hoped that the inability of the system to apply the interest rate to control inflation will not be an excuse given by the ignorant to further suppress the interest rate and intensify the regressive direction of the economy. If that’s going to happen, I beg officials of the central bank not to take any action, except in an emergency.
