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.

Russia’s invasion of Ukraine, the worldwide energy crisis, on-and-off lockdowns in China and pandemic-era supply bottlenecks have come together to provide an explosive cocktail of spiralling prices.

The whole lot, it seems, is becoming impossibly expensive.

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

The European Central Bank (ECB) has bumped rates thrice in 4 months, putting an abrupt end to a protracted chapter of negative rates dating back to the worst years of the EU’s sovereign debt crisis

Its counterparts within the UK, Sweden, Norway, Canada, South Korea and Australia have all taken similar steps in response to daunting inflation readings.

The Federal Reserve of the US has delivered three consecutive jumbo hikes of 0.75 basis points, with similar moves coming down the pipeline.

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 bunch 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 manage 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 an uphill struggle for everyone: consumers, businesses and governments are all left to scramble to make ends meet.

“High inflation is a serious 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

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

Industrial banks must present a invaluable asset – referred to 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 facility to set its own rates of interest, which effectively determines the value of cash.

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

The logic is predicated on a cascading effect: if central banks charge higher rates to business banks, business banks in turn increase the rates they provide to households and businesses who want to borrow.

In consequence, personal debt, automotive loans, bank cards and mortgages turn costlier and folks change into more reluctant to request them.

Corporations that commonly ask for credits to make investments begin to think twice before making a move. Meanwhile, governments are forced to make higher payments for his or her national debt.

Tighter financial conditions inevitably result in a fall in consumer spending across most or all economic sectors.

Fundamental economic rules show that when demand for goods and services declines, prices follow suit. This is strictly what central banks intend to do at present: curb spending to curb inflation.

But the results of monetary policy can take as much as two years to materialise and are due to this fact unlikely to supply a right away solution to probably the most pressing challenges.

Complicating matters is the incontrovertible fact that energy is currently the fundamental driver behind inflation, fuelled by an element totally unrelated to the economy: Russia’s unprovoked invasion of Ukraine.

Electricity and gasoline are commodities that almost all people use no matter how much they cost, so a fast and drastic 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: being profitable costlier can decelerate growth, weaken salaries and foster unemployment.

“The possibilities of a soft landing are prone to diminish to the extent that policy must be more restrictive,” US Federal Reserve chair Jerome Powell has said.

“Nobody knows whether this process will result in a recession or, in that case, how significant that recession could be.”


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