Low rates, high risks: The drawbacks of a growth-first monetary policy

More and more developing countries are rethinking the basics of monetary policy. Some policymakers have shifted to a "growth-first" approach because inflation remains high, investment remains weak, and societal constraints limit the ability to keep people employed. They say that lower interest rates can boost production and cut inflation at the same time.

This perspective opposes the prevailing orthodoxy that emphasises price stability via more stringent monetary conditions. It is based on what seems like a simple idea: high borrowing rates stop companies from investing, whereas lower interest rates make them want to grow, hire more people, and eventually make supply-side problems easier to solve.

But recent experience shows that this approach, while it sounds good in principle, may not fully understand how complicated modern macroeconomic dynamics are.

The success of interest rate policy is heavily dependent on the overall state of the economy. People don't only make investment decisions based on how much it costs to borrow money; they also think about how stable the future will be. In times of high or unstable inflation, reducing interest rates may not be enough to get people to invest in things that will help the economy. Instead, they can make things less certain, mess with pricing signals, and encourage short-term, defensive financial behaviour.

The relationship between interest rates and exchange rates makes things much more complicated. In open economies, lowering interest rates can cause capital to leave the country, thereby putting downward pressure on the domestic currency. Currency depreciation, on the other hand, causes inflation by raising the cost of imports. This is especially true in economies that depend on imported goods.

Türkiye is a good example, but not the only one. Over the past several years, policy has focused on low interest rates to boost the economy. But the combination of lower interest rates and exchange rate pressure has led to higher inflation, mostly due to exchange rate pass-through. The outcome has been a decline in macroeconomic stability, which is exactly what is needed for long-term investment.

This trend is not limited to one country. It shows a broader structural problem in many emerging markets, where external vulnerabilities remain a major concern. Having a lot of foreign-currency debt, insufficient reserve buffers, and reliance on external capital flows make a country more sensitive to changes in the global financial situation.

Dollarization, or more generally, currency substitution, makes things even more complicated. When people and businesses keep a lot of their money in foreign currency, domestic monetary policy doesn't work as well. In such situations, trying to lower interest rates can accelerate capital flight and make people less confident in the local currency, worsening inflation.

In light of this, the idea that inflation can be fixed mainly by expanding the supply side without first stabilising prices seems overly optimistic. Price stability is not only one of many goals; it is necessary for market economies to work. Long-term contracts become riskier, financial intermediation weakens, and investment horizons decrease without it.

It would be too simple to say that inflation is the only reason why the economy isn't doing well. Many new economies face more serious structural problems, such as slow productivity growth, insufficient technology upgrading, and ongoing current account imbalances. Monetary policy, whether traditional or non-traditional, cannot replace these changes.

In fact, focusing too much on interest rates can take attention away from the bigger policy agenda. For growth to be sustainable, the quality of institutions, the skills of workers, and the capacity of industries all need to get better. It also needs a financial framework that can effectively distribute resources to sectors that create value.

In this situation, more and more people are interested in various financial models that focus on sharing risk and financing assets. Islamic finance, for instance, provides a structure that more directly links financial returns to actual economic activity and deters speculative activity. Even if these tactics have their limits, they may help people become more financially stable, especially in unstable situations.

Technological changes are also transforming the world of finance. Fintech has made it easier for people to access financial services and lowered transaction costs. It has also accelerated and increased cross-border capital flows. This can make macroeconomic management harder by increasing both risks and opportunities.

At the same time, the ups and downs of cryptocurrency markets have shown how difficult it is to use alternative assets to protect against inflation. These tools have often added more uncertainty rather than making things more stable.

The "impossible trinity" of international macroeconomics highlights the policy trade-offs that rising economies still face. This means they can't maintain fixed exchange rates, unfettered capital mobility, and independent monetary policy at the same time. Unconventional monetary easing can complicate efforts to balance these goals, and the markets quickly pick up on these complications.

So, what does this mean for people who make policy decisions?

First and foremost, restoring and keeping price stability should be the major goal. This doesn't mean that you have to strictly follow orthodox policy prescriptions, but it does mean that you have to make a credible promise to keep inflation under control.

Second, monetary policy needs to be backed by broader structural changes that will boost productivity and address trade issues. If these kinds of changes don't happen, trying to boost GDP by expanding credit is unlikely to work in the long run.

Third, it's important to restore faith in your country's currency. This means not only good management of the economy as a whole but also trust in institutions, especially in the perceived independence and efficacy of central banks.

Finally, financial systems should be redesigned to encourage long-term investment rather than short-term speculation. This process can be aided by diversifying financial instruments, such as creating capital markets and other channels to raise money.

It's easy to see why growth-first monetary policies are appealing, especially in places with social and political constraints. But recent experience shows that these strategies are very risky when they aren't grounded in macroeconomic stability.

The main point is not that unusual policies should be thrown out immediately, but that they only work in certain situations and when they are credible and consistent. Without these, trying to stimulate the economy by lowering interest rates could not only fail, but also make things worse.

Ultimately, the relationship between growth and stability is not a trade-off to be handled, but a complementarity to be comprehended. For economic progress to be sustainable, both are needed. Policies that hurt one are not likely to help the other.

Sketch: TBS

Mohammad Kabir Hassan is Professor of Finance in the Department of Economics and Finance at the University of New Orleans

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.