In 1973, the Israel-Arab war in the Middle East led to an oil embargo for the western countries, leading to a spike in oil prices and spiralling inflation.
The oil-producing bloc increased the oil price fourfold. The same happened in 1979 after a revolution in Iran. Today’s war in Ukraine has led to another oil crisis incorporating gas, which is piped to western Europe.
How shall we react? Rising prices - inflation - is political leaders’ worst nightmare. It negates the famous mantra that government has no business in business. It is no wonder the leading presidential contenders are talking about the rising cost of living.
What are the options to stop the rising prices?
The immediate reaction is to raise interest rates to reduce the amount of money in circulation.
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We borrow less at higher interest. This reduces the demand for goods and services and brings down the prices. The US, UK, Australia, Kenya and several other countries have raised their interest rates.
Ironically, they had cut the rates to caution their economies against the ravages of Covid-19. No one thought we could raise the rates so soon.
Discovering the Covid-19 vaccine led to a quick economic rebound and inflation pressures, more so for the West which made credit easily available including sending free cheques to its citizens.
We missed that! The underside of a hike in rates is that it could precipitate a recession. With less borrowing and spending, the falling demand could lead to job losses and negative economic growth.
The monetary policy shift best espoused by the change in interest rate is not the only tool at the government’s disposal to fight inflation.
More on that later. A high-interest rate means the government itself borrows at higher rates, which could entice us to buy more government debt, a good investment for corporations and individuals.
Tried it? Government borrowing through Treasury bills and bonds takes money from the private sector, which is often more efficient. This crowding effect can be a further drag on the economy.
In the globally interconnected economy, money can flow from one country to another seeking higher returns. We are already feeling the effect of that.
Higher interest rates in the US are attracting money, leading to a higher demand for dollars.
That leads to its appreciation. Now you know why our shilling is depreciating. The other policy approach is to reduce government spending, which creates further demand in the economy.
That, coupled with high-interest rates, could increase the chances of a recession and affect too many jobs. This perhaps explains why monetary policy is so popular. All is not lost, the State could give incentives to innovators to ride through the crisis.