Why do central banks raise their interest rates to fight inflation?

Why do central banks raise their interest rates to fight inflation?

All prices are going up: fuels, electricity, gas, fruits and vegetables, hotels, and now, interest rates.

The war in Ukraine, successive lockdowns in China, continuing energy shortages and disrupted production chains have created a strong appetite for goods and services, disrupting the delicate balance between supply and demand. This has resulted in prices rising to record highs. Inflation, or the overall rise in prices, is beginning to worry many governments.

In a quasi-synchronous fashion, central banks around the world are rushing to raise their key interest rates in the hope of bringing galloping inflation under control.

For its part, the European Central Bank (ECB) has become one of the last institutions to change its monetary policy, thus ending a long chapter of negative rates dating back to the worst years of the public debt crisis in the states of the European Union.

In response to alarming inflation figures, central banks in the UK, Sweden, Norway, Canada, South Korea and Australia have all taken similar action in recent months. .

The American Central Bank (Fed) also raised, on June 15, its key rates by three quarters of a percentage point, ie the largest increase since 1994, in an attempt to control stronger than expected inflation.

What is the economic mechanism that justifies such a decision?

The central bank of a country is above all an independent institution, charged by the State with deciding to apply monetary policy. In the case of the European Central Bank (ECB), it is a community institution which represents the nineteen countries of the European Union which have adopted the euro.

These banks have the power to issue banknotes and coins, control foreign exchange reserves, act as emergency lenders and ensure the health of the financial system.

The primary mission of a central bank is to ensure price stability. This means that it must control both inflation – when prices rise – and deflation – when prices fall.

**Why do central banks decide to raise rates, then it may cause a slowdown in the economy? **

Low rates generally allow for higher economic growth and thus lower unemployment. If, on the contrary, key interest rates rise, growth and employment fall, because less liquidity is granted to the economy.

This is why all central banks set themselves a moderate and positive inflation target, generally around 2%, in order to encourage gradual and steady growth.

But when inflation starts to soar, the central bank is in big trouble.

Indeed, too high inflation can quickly undermine the profits reaped during the boom years, reduce the value of savings and swallow up corporate profits.

Bills are getting more expensive for everyone: consumers, businesses and governments are all in trouble.

This is where monetary policy comes into play.“High inflation is a major challenge for all of us,” said Christine Lagarde, President of the ECB during her press conference on June 9.

The central bank is the “bank of banks”

Commercial banks, the ones we turn to when we need to open a bank account or take out a loan, borrow money directly from the central bank to meet their most immediate financial needs.

Commercial banks must present a valuable asset, called “guarantee”, which precisely guarantees that they will be able to repay this money. Government bonds, the debt issued by governments, are among the most common forms of collateral.

In other words, a central bank lends money to commercial banks, and commercial banks lend money to households and businesses to support growth.

When a commercial bank repays its debt to the central bank, it has to pay an interest rate. The central bank therefore has the power to set its own interest rates, which thus determines the price of money.

If the central bank imposes higher rates on commercial banks, the latter in turn increase the rates they offer to households and businesses that need to borrow to invest.

As a result, home loans, consumer loans, credit cards are more expensive and households are becoming more reluctant to approach financing organizations. Companies, which need banks for their future investments, are beginning to think twice before acting. Hence the slowdown in the economy.

The results of economic policies do not come immediately

The tightening of financial conditions inevitably leads to a drop in consumption in the majority of economic sectors. When the demand for goods and services decreases, their prices tend to fall.

This is exactly what central banks intend to do: cut spending to curb inflation.

But the effects of monetary policy can take up to two years to materialize and are therefore unlikely to offer an instant solution to the most pressing problems.

Moreover, what complicates the situation even more is that energy is today the main factor of inflation, strongly fueled by an element not directly related to the economy: the invasion of Ukraine by Russia.

Gasoline and electricity are staples that everyone uses, regardless of cost, so a rapid drop in demand to lower prices won’t be that simple.

Central banks, like the Fed, have bet on taking drastic measures, even if this risks impacting the economy. Aggressive monetary policy is like walking on a tightrope: making money more expensive can slow growth, lower wages and boost unemployment.

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