Why do central banks raise interest rates to curb inflation?

It’s all going up: electricity, diesel, vegetables, the Web, hotels, flights, and now, rates of interest.

The war in Ukraine, the on-and-off lockdowns in China, a persistent power crunch and disrupted production chains have bumped right into a huge appetite for goods and services, upsetting the fragile balance between supply and demand and driving prices to record highs.

In an almost synchronised manner, central banks from all around the globe are rushing to boost their key rates of interest in a bid to tame soaring inflation, which, much to their dismay, continues to interrupt monthly records.

The European Central Bank (ECB) became one in every of the newest institutions to shift monetary policy, closing a protracted chapter of negative rates dating back to the worst years of the EU’s sovereign debt crisis.

Its counterparts in Sweden, Norway, Canada, South Korea and Australia have all taken similar steps in recent months, reacting to daunting inflation readings. The Federal Reserve of the US hiked rates twice by 0.75 percentage points, the largest increase since 1994.

The Bank of England recently raised rates of interest by the biggest amount in greater than 27 years.

But what exactly is the rationale behind this move?

Central banks are public institutions of a singular nature: they’re independent, non-commercial entities tasked with managing the currency of a rustic or, within the case of the ECB, a gaggle of nations.

They’ve exclusive powers to issue banknotes and coins, control foreign reserves, act as emergency lenders and guarantee the great health of the economic system.

A central bank’s prime mission is to make sure price stability. This implies they need to regulate each inflation – when prices go up – and deflation – when prices go down.

Deflation depresses the economy and fuels unemployment, so every central bank sets a goal of moderate, positive inflation – often around 2% – to encourage gradual, regular growth.

But when inflation begins to skyrocket, the central bank is in serious trouble.

Excessive inflation can rapidly shatter the advantages reaped in previous years of prosperity, erode the worth of personal savings, and eat up the profits of personal corporations. Bills change into costlier for everyone: consumers, businesses, and governments are all left to scramble to make ends meet.

“High inflation is a significant challenge for all of us,” ECB President Christine Lagarde has said.

That is the moment when monetary policy comes into play.

A banker’s bank

Business banks, those we go to when we’d like to open an account or take out a loan, borrow money directly from the central bank to cover their most immediate financial needs.

Business banks need to present a helpful asset – generally known as collateral – that guarantees they are going to pay this a refund. Public bonds, the debt issued by governments, are amongst probably the most frequent types of collateral.

In other words, a central bank lends money to business banks, while business banks lend money to households and businesses.

When a business bank gives back what it borrowed from the central bank, it has to pay an rate of interest. The central bank has the ability to set its own rates of interest, which effectively determines the worth of cash.

These are the benchmark rates that central banks are currently raising to tame inflation. 

If the central bank charges higher rates to business banks, business banks in turn increase the rates they provide to households and businesses who must borrow.

Consequently, personal debt, automobile loans, bank cards, and mortgages are costlier and other people change into more reluctant to request them. Firms, that repeatedly ask for credits to make investments, begin to think twice before making a move.

Tighter financial conditions inevitably result in a fall in consumer spending across most or all economic sectors. When demand for goods and services decreases, their price tends to say no.

This is strictly what central banks intend to do now: curb spending to curb inflation.

But the results of monetary policy can take as much as two years to materialise and are subsequently unlikely to supply an quick solution to probably the most pressing challenges.

Complicating matters is the proven fact that energy is today the principal driver behind inflation, strongly driven by an element unrelated to the economy: Russia’s invasion of Ukraine.

Gasoline and electricity are commodities that everyone uses no matter how much they cost, so a fast drop in demand to chill prices can’t be taken with no consideration.

This explains why central banks, just like the Fed, are taking such radical steps, even when it finally ends up hurting the economy. Aggressive monetary policy is a tightrope walk: getting cash costlier can decelerate growth, weaken salaries, and foster unemployment.

“We’re not attempting to induce a recession,” US Federal Reserve chair Jerome Powell has said. “Let’s be clear about that.”


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