Interest rates

Why do central banks raise interest rates to contain inflation?

Everything goes up: electricity, diesel, vegetables, internet, hotels, flights and now, interest rates.

The war in Ukraine, intermittent shutdowns in China, a lingering electricity crisis and disrupted production chains have collided with a huge appetite for goods and services, upsetting the delicate balance between supply and demand and pushing prices at record highs.

In near-synchronous fashion, central banks around the world are rushing to raise policy rates to tame soaring inflation which, to their dismay, continues to set monthly records.

The European Central Bank (ECB) has become one of the last institutions to change its monetary policy, close a long chapter negative rates dating back to the worst years of the EU sovereign debt crisis.

Its counterparts in the UK, Sweden, Norway, Canada, South Korea and Australia have all taken similar action in recent months, reacting to disheartening inflation figures. In a single announcement, the US Federal Reserve raised rates by 0.75 percentage points, the biggest increase since 1994.

But what exactly is the justification for this movement?

Central banks are public institutions with a unique character: they are independent, non-commercial entities responsible for managing the currency of a country or, in the case of the ECB, of a group of countries.

They have the exclusive power to issue banknotes and coins, to control foreign exchange reserves, to act as emergency lenders and to guarantee the good health of the financial system.

The primary mission of a central bank is to ensure price stability. This means they have to control both inflation – when prices go up – and deflation – when prices go down.

Deflation depresses the economy and fuels unemployment, so each central bank sets a moderate positive inflation target – usually around 2% – to encourage gradual and steady growth.

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

Excessive inflation can quickly wipe out profits reaped in previous boom years, erode the value of private savings, and erode the profits of private businesses. Bills are getting higher for everyone: consumers, businesses and governments are all scrambling to make ends meet.

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

This is when monetary policy comes into play.

A banker’s bank

Commercial banks, the ones we go to when we need to open an 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 – known as collateral – which guarantees that they will repay that 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, while commercial banks lend money to households and businesses.

When a commercial bank returns what it borrowed from the central bank, it must pay an interest rate. The central bank has the power to set its own interest rates, which effectively determines the price of money.

These are the reference rates that central banks are currently raising to control inflation.

If the central bank charges commercial banks higher rates, commercial banks in turn raise the rates they offer to households and businesses that need to borrow.

As a result, personal debt, car loans, credit cards and mortgages are more expensive and people are becoming more reluctant to apply for them. Companies, which regularly apply for credit to invest, are beginning to think twice before launching.

Tighter financial conditions inevitably lead to lower consumer spending in most or all economic sectors. When the demand for goods and services decreases, their price tends to fall.

This is exactly what central banks intend to do now: rein in spending to rein in inflation.

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

To complicate matters, energy is today the main driver of inflation, strongly fueled by a factor unrelated to the economy: the invasion of Ukraine by Russia.

Gasoline and electricity are staples that everyone uses, regardless of cost. A rapid drop in demand to cool prices cannot therefore be taken for granted.

This explains why central banks, like the Fed, take such drastic measures, even if it ends up hurting the economy. Aggressive monetary policy is a tightrope walk: making money more expensive can slow growth, lower wages and boost unemployment.

“We’re not trying to cause a recession,” US Federal Reserve Chairman Jerome Powell said. “Let’s be clear about this.”