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Interest rates and inflation, the delicate balance with which central banks operate

Surely you have already realized it: everything is going up. Electricity, gasoline, vegetables, hotels, flights… Well, to all this we must add something equally or probably more important: interest rates.

The war in Ukraine, the intermittent closures and confinements in China, the persistent shortage of energy or the interruption of production chains coincide these days with a huge appetite for goods and services, which it alters the always delicate balance that exists between supply and demand. That inevitably drives prices to all-time highs.

Almost synchronously central banks around the world are rushing to raise their interest rates key, in an attempt to curb rising inflation that continues to break monthly records.

The European Central Bank has been one of the last institutions to change its monetary policy, closing a long chapter of negative rates that dates back to the worst years of the European Union’s sovereign debt crisis.

Their counterparts in the UK, Sweden, Norway, Canada, South Korea and Australia have taken similar steps in recent months, reacting to disappointing inflation figures. For its part, the US Federal Reserve raised rates by 0.75 percentage points, the largest increase since 1994. But what exactly is the reason for these decisions?

Central banks are public institutions of a unique nature: they are independent and non-commercial entities in charge of managing the currency of a country or, in the case of the ECB, of a group of countries. A) Yes, have exclusive powers to issue banknotes and coinscontrol foreign exchange reserves, act as emergency lenders and ensure the good health of the financial system.

Of course, the main mission of a central bank is to ensure price stability. This means that they have to control both inflation – when prices go up – and deflation – when they go down.

Deflation depresses the economy and fuels unemployment, which is why in the face of it all central banks set a moderate and positive inflation target -generally around two percent- to thereby encourage gradual and steady growth. Now, when inflation starts to skyrocket, trouble begins for the central bank.

Excessive inflation can quickly wipe out the harvest of boom years, erode the value of private savings, and eat away at the profits of private businesses. Suddenly bills become more expensive for everyone, and consumers, businesses and governments alike are forced to struggle to make ends meet.

“High inflation is a great challenge for all of us”, recognized these days the president of the ECB, Christine Lagarde. It is at times like this that monetary policy comes into play.

A bank of bankers

Commercial banks, the ones we go to when we need to open an account or request a loan, borrow money directly from the central bank to cover their most immediate financial needs. But for this they have to present a valuable asset – known as collateral – that guarantees that they will return that money. Government bonds, that is, debt issued by governments, are one of the most frequent forms of collateral.

In summary, the central bank lends money to commercial banks, which in turn lend money to households and businesses.

When a commercial bank pays back what it has borrowed from the central bank, it has to pay an interest rate. The central bank has the power to set its own interest rates, what in fact determines the price of money. Well, these are the reference rates that central banks are currently raising to control inflation.

Because if the central bank charges higher rates to commercial banks, they, in turn, increase the rates they offer to households and businesses that need to borrow. As a result, personal debt, car loans, credit cards or mortgages are more expensive, and people are more reluctant to apply for them. Companies, which usually request loans to make investments, are beginning to think twice before taking the step.

Ultimately, tighter financial conditions inevitably lead to a drop in consumer spending in most or all economic sectors. And when the demand for goods and services decreases, their price tends to fall. And this is exactly what central banks intend to do now: curb spending to curb inflation.

But the truth is that the effects of monetary policy can take up to two years to materialize, so they are unlikely to offer an instant solution to the most pressing problems. To complicate things, energy is today the main engine of inflationstrongly driven by a factor other than the economy: the Russian invasion of Ukraine.

Gasoline and electricity are basic products that everyone uses regardless of what they cost, so it is difficult to expect a rapid decline in demand that will cool prices.

This explains why central banks, such as the US Federal Reserve, are taking such radical measures, even if they end up hurting the economy. In truth, aggressive monetary policy is a tightrope walk, because making money more expensive can slow down growthweaken wages and promote unemployment. Jerome Powellchairman of the Fed, tries to be blunt about it: “We are not trying to induce a recession. Let it be clear.”

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Written by Editor TLN

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