All major Central Banks aspire to keep inflation level at an ideal 2% in their respective countries. Anywhere it is lower or higher than this rate is the problem. For example, around the COVID-19 pandemic time, the inflation rate hovered way below this ideal rate. After the pandemic and post-Russia-Ukraine war, the inflation has gone way ahead of target, as in the US, it is 8.1%, and 8.6% in the UK.
This rise in inflation has led central banks to undertake the task of controlling it in their respective countries. The question is, can central banks really control inflation? What tools do they have to control inflation?
To answer these questions, first look at how the recent inflationary pressures in the USA, UK, and Eurozone specifically came about.
What Is Causing the Recent Rise in Inflation Rates?
Ever since the lockdown lifted after the pandemic, there has been a consistent rise in inflation everywhere. The root causes of this inflation pressure are both supply and demand-side factors. Many central banks claim that recent inflation is the aftermath of the lockdown. Furthermore, the Russian invasion of Ukraine escalated it by causing an energy crisis.
It is a general view that inflation in the USA has been generated by rising demand. Stimulus checks were given by the Government during the pandemic to people to enable them to manage their activities during the lockdown enhanced their purchasing power. It in return, increased demand for goods and services in the USA, leading to inflation.
On the contrary, Eurozone inflation comes supply shortages. Worker shortages and other supply-chain issues caused by the COVID-19 pandemic and rising gas prices due to the war in Ukraine are the main reason for inflation.
What Are Tools Central Banks Use To Control Inflation?
As you can see, the current inflation waves have not been generated by any central banks’ actions. Regardless, they still believe they can control it by playing around with three tools.
The first tool is the monetary policy. Here, the central banks play with any monetary policy strategy to increase interest rates. Central banks increase the discount rate, which is the rate charged to other banks for borrowing funds from the central bank. Similarly, the central bank also raises the rate it pays to other banks that deposit funds or reserves with them. All these actions increase the interest rates and cost of borrowing for individuals and businesses.
The second tool is forward guidance. Here the central banks communicate the future course of monetary policy and the interest rates. It is to tell households, businesses, and investors the monetary policy intentions to prevent surprise shocks. It avoids disruptions and chaos created in the markets due to sudden changes in the interest rates that fluctuate asset prices considerably.
The final tool to crush inflation that central banks use is reducing the size of their balance sheet or quantitative tightening. They tighten their balance sheet by selling government bonds and assets from their balance sheets. It increases the supply of long-term assets in the market and reduces the money supply. When the money supply decreases, it reduces the money available for borrowing, thus increasing interest rates.
So, in short, all these tools end up increasing interest rates to curb inflation in an economy.
How Can Central Banks Tools Control Inflation?
We have discussed three tools that government employs to curb inflation in any economy. All economists agree that rising interest rates reduce households and businesses’ demands. When interest rates increase, the cost of borrowing also increases. So, central banks, by manipulating interest rates make borrowing less attractive to consumers.
On the contrary, with the rise in interest rates, stock asset prices also go down, while bonds, certificates of deposits, and others become more attractive due to the higher yield. This reduction in stock prices also has a psychological impact on people who own them. It can urge them to think they are getting poorer, thus deterring their expenditures.
In these situations, companies get less interested in hiring new people, raising salaries, and even lay off a few, which would further reduce demand in an economy.
With higher interest rates, people become less interested in making credit purchases, which further plummets the demand for goods and services. Many companies might face financial problems and can even go out of business due to less availability of credit or more expensive credit. It can lead to the firing of employees, which further decreases demand due to the loss of income.
Similarly, communicating about the potential rise in interest rates in the case of forward guidance also can reduce current demand due to expectations of the high cost of borrowings.
Central banks use three tools to increase the cost of borrowings and reduce the value of the assets to discourage demand to curb inflation. In this process, they make many people lose their jobs and poorer, as per many criticisms.
However, the central banks know how far to take things. When they observe things gone too far, they balance it with their other policies to prevent any crisis.
So, we can conclude that central banks’ tools can impact inflation, however, the relationship between these tools and inflation is complex and require constant adjustments of the monetary policy to meet the right balance.