The situation all over the world is far from ideal. The list of problems is very long. For instance, the situation in Ukraine, the on-and-off lockdowns in China, the world’s second-largest economy, etc. The list of problems is very impressive.
In an almost synchronized manner, central banks from all over the globe are rushing to increase their key interest rates in an attempt to tackle inflation, which, much to their dismay, continues to break monthly records.
The European Central Bank (ECB) also decided to change its monetary policy.
The ECB’s counterparts in the United Kingdom, Norway, Sweden, Canada, Australia, and South Korea took similar steps in recent months, reacting to intimidating inflation readings.
Interestingly, the U.S. Federal Reserve hiked rates by 0.75 percentage points, the most significant increase in a very long time.
However, what exactly is the rationale behind this move?
People should keep in mind that central banks are public institutions of a unique nature: central banks are independent, non-commercial entities tasked with managing the currency of a country or, in the case of the European Central Bank, a group of countries.
Central banks have exclusive powers to issue banknotes as well as coins, control foreign reserves, etc.
A central bank’s major mission is to ensure price stability. This means central banks need to control both inflation – when prices go up – and deflation – when prices go down.
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What makes central banks so important?
Deflation affects the economy and fuels unemployment, so every central bank sets a target of moderate, positive inflation – in most cases around 2% – to support gradual growth.
However, when inflation begins to skyrocket, the central bank is in deep trouble, to say the least.
Excessive inflation can quickly shatter the benefits reaped in previous years of prosperity. It can erode the value of private savings and eat up the profits of private companies. Unsurprisingly, bills become more expensive for everybody: consumers, businesses, and governments are all left to scramble to make ends meet.
Importantly, this is the moment when monetary policy comes into play.
Commercial banks borrow money directly from the central bank in order to cover their most immediate financial needs.
They have to present a valuable asset – known as collateral – that guarantees commercial banks will pay this money back. Interestingly, public bonds, the debt issued by governments, are among the most widespread forms of collateral.
However, when a commercial bank gives back what it borrowed from the central bank, the commercial bank has to pay an interest rate.
It is worth noting that the central bank has the power to set its own interest rates, which effectively dictates the price of money.
Notably, these are the benchmark rates that central banks are currently raising to tackle inflation.
For example, If the central bank charges higher rates to commercial banks, commercial banks, in turn, increase the rates they offer to households as well as businesses who need to borrow.
Monetary policy and potential problems
Consequently, personal debt, credit cards, car loans, and mortgages are more expensive, and people become more reluctant to request them.
Tight financial conditions inevitably lead to a fall in consumer spending across most or all economic sectors. When demand for goods and services decreases, the price of goods and services tends to decline.
This is precisely what central banks plan to do at the moment: curb spending to curb inflation.
Nevertheless, the effects of monetary policy can take up to two years to materialize and are therefore not likely to offer an immediate solution to the most critical issues.
Besides, complicating matters is the fact that energy is now the main driver behind inflation. It is strongly driven by a factor unrelated to the economy: Russia’s invasion of Ukraine.
Gasoline, as well as electricity, are commodities that everyone uses regardless of how much they cost; hence, a quick drop in demand to cool prices can’t be taken for granted.
This explains why central banks, like the Federal Reserve, are taking such radical steps, even if it ends up hurting the economy.