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The reaction of central Banks to inflation

Updated: Apr 4, 2022


Inflation is the result of individual businesses raising the prices of their goods and services gradually. Every single business chooses the rate with which prices rise individually. These rates of all business are then summed up in the CPI, giving us the inflation rate. But why do central banks make such a fuss over basic decisions of businesses? Why not just let inflation happen? Wouldn’t that be in accordance with this “Free market economy” that we were promised? It turns out, in order to keep an economy functioning and well, the central banks of the world have to step in and do damage control. Let’s look at what they do in inflation and at what they might have already done…


Why do Central Banks care about inflation and how do they control it?

As we have seen the past months, the central banks of the world (for this purpose I shall only be referring to the Federal Reserve and the ECB as “Central banks of the world”) are keen on keeping inflation low, preferably 2-3%. This is because they believe keeping inflation low and stable will perpetuate economic growth. But how can this be? Well, as I mentioned above, the rate with which businesses raise their prices is entirely up to them. There is no “official” guideline as to what that rate should be. Business owners muss asses the monetary value of their products and services on their own and they can get a tad carried away…


Money has a price

When the supply of money increases, inflation gets higher, as businesses see that with more money out there, people are willing to pay more for their products. But why does the money supply increase? That has to do with three things the government:

  • Prints money

  • Lends money to businesses

  • Buys corporate bonds (which is basically the same thing as lending money to businesses)

In this post we shall be looking at the latter two, because that’s the main way businesses get money: Loans. The increased availability of money is caused by the “price” of money. But how can money have a price? Money is money!

Well, yes, but the “price” that I am referring to is the interest rate on loans from the US government to central banks. If this interest rate (also known as the bank- or discount-rate) is low, the money that is being lent is “cheaper”.


Bonds and Quantitative Easing

Now let’s talk about buying corporate bonds. Bonds are basically a “reverse loan”. This means that the interest rate is determined by the debtor. In fact, bonds are issued by debtors. The government buys bonds to let new money flow into the economy. This monetary policy is called Quantitative easing (QE). This increase in money supply causes, you guessed it, inflation. The government uses this method to increase inflation on purpose. Why do they do that? That’s a topic for another post. Anyway, since inflation is too high at this point, the government has to do exactly the opposite: Make the inflation rate lower. And they can do that by doing the opposite of quantitative easing: Buying less bonds. This will stop money from flowing into the economy, or at the very least hinder it from flowing into the economy for a while. That’s actually what central banks have been doing, but before we get into that, you should know that this entire process is called Inflation targeting (setting a certain Inflation rate as a target and then adjusting monetary policy to achieve said target).


The Federal Reserve

The Federal reserve, or Fed, is the most powerful central bank in the world. The impact they have on the world economy is immense. In contrast to the other Central Banks of the world, the Fed isn’t owned by the government, but is instead set up like a private corporation. So, what they do is of the utmost importance to us, especially in this case:

The Fed has made it clear that it is their belief that this surge in inflation will just be short-lived, with Fed Chair Jay Powell saying that while high inflation is “a cause for concern”, it is merely “temporary”.

Still the “cause for concern” part has left the Fed thinking about what to do and even if it should do anything. Back in July, a bond buying taper was suggested. The plan was to start the taper this year, but to be honest, things are kind of a mess right now with the Fed still arguing about what to do. Several Fed officials (regional bank presidents) said that they were keen on getting the taper underway and reduce the purchase of assets as quick as possible. Powell said that if jobs would continue to grow, he would deem it appropriate to start with the taper “this year”. The debate will continue at the Feds meeting later this month. As of now however, we don’t know exactly when the taper will start. Most likely “soon”, according to them.

And what does the Fed think of raising interest rates? Powell said that the Fed will be cautious when it comes to raising interest rates, as taking such a drastic measure would be inappropriate given the alleged “transitory” nature of high inflation. Raising interest rates would have the effect of halting job growth which would be bad for the economy.


Currently, we should only be thinking about reducing asset purchases, but before we raise interest rates the situation has to worsen.


The ECB

The European Central bank is the European version of the Fed and also an incredibly important Central bank. They have already begun with implementing anti-inflation measures.

The ECB announced that it would taper its PEPP program, the emergency pandemic program, to make sure that businesses wouldn’t go bankrupt by keeping borrowing rates low. Even though it isn’t equivalent to a bond taper it will definitely counteract inflation and could encourage the Fed to finally do something.


Conclusion

Central banks say that inflation is only temporary and have not been forced to take extreme measures to counteract it. The ECB is more progressive than the Fed which might motivate them to make a move. Currently, central banks have to watch inflation rates carefully to decide whether raising interest rates is truly worth it.

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