After interest-rate cuts and huge quantitative easing in 2020, investors felt that central-bank stimulus would last forever. But free money was coming to an end as COVID-stricken economies began to recover. A tide of inflation was carried alongside them, reaching peaks not seen for 40 years. Central banks scrambled to minimise the impact by increasing rates; the Bank of England (BoE) was first, announcing rate hikes in December, followed by similar hawkish sentiments from the Federal Reserve and the European Central Bank (ECB). Yet rates remain high, and it appears that banks are failing their job.
There are many reasons why demand would overtake supply: firstly, such as in the case of COVID, when stimulus packages were employed by governments around the world to churn the drying economic pot. This included providing monetary support for displaced workers and suffering small businesses, as well as direct payments to families. Now that more people had more money to spend, demand increased. Secondly, such as in the case of Ukraine, when supply chains are cut; energy prices spiked in Europe since they rely on gas from Russia. Thirdly, such as in the UK after Brexit, when banks cut rates, there was incentive to borrow, and so more money was put into circulation. In all three instances, prices go up as more people want the same things.
Although often accompanied by robust economic growth, the reality is that this just clouds the danger of rising prices. For households, inflation eats into savings and spreads fear into markets, decreasing the value of owned stocks. The prices of basic goods also increase. Given that lower-income households tend to spend a larger percentage of their wealth on essentials, which often increase more in price since they are in higher demand than luxuries, they are affected disastrously. Therefore, inflation must be controlled before it destroys the lives of those most at risk.
To keep inflation in check, one must curb demand so that it is in line with supply. Governments cannot just recall the money from the stimulus during COVID, as they were grants and didn’t need to be repaid. Increasing supply to meet demand is difficult as most manufacturers are incapable of making products rapidly when told to do so and as a result they require months to adjust to this new demand, keeping inflation high and dangerous for a long time. In the case of Ukraine, cut supply chains have multiple political factors stopping them from being reopened, such as unwillingness to sacrifice human life.
In the three circumstances outlined above, the only way that inflation can be immediately lessened is by the central banks; they can do so without having to rely on the global cooperation needed for increasing supply or upsetting the public majorly. The way banks combat inflation is by reducing the supply of money within the economy, to reduce overheating and the ability to demand.
One way they can do this is by raising rates, which reduces borrowing, and therefore decreases the total supply of money. Although they are unable to directly set rates of loans such as mortgages, they can influence them by increasing the rate at which commercial banks can borrow from them. These rates are passed on to the public, and spending drops, which reduces demand and consequently inflation. When interest rates rise, savers are also less likely to spend their current savings, as they can get a better return from it. Spending is decreased even further.
Another way banks can reduce demand is by engaging in open market operations. For example, having bought many government bonds at the start of COVID, they would sell these. This process is known as quantitive easing (QE). In exchange for bonds being resold to the government, cash is removed from the economy. Once again, the supply of money is lowered, and inflation is put on leash.
But even with all these possible approaches, the ECB looks more dovish than its counterparts. It wants to keep a balance of minimising rate rises while not progressing into recession. Especially concerning for Europe is Russia’s war against Ukraine, which has made energy prices skyrocket. Oil and gas outmanoeuvre the actions of the ECB because it is an imported cost which the bank has little control over. This means that the ECB is heavily reliant on the outcome of the war to see how far it can chain inflation.
Another reason some central banks are unable to manage inflation is because of their lack of independence. In Turkey, Erdogan runs the central bank like a government agency, forcing it to continue slashing rates, stating they are the cause of inflation, not the solution. The results are a near 50% inflation. He is also raising wages to appease the public, but this just drives inflation further. In 2013, Maduro, the Venezuelan president, printed more money to fight expensive imports.
Credit must be given where credit is due: central banks they are doing their job well. In an ideal world, monetary policymakers have the option to change course whenever they want. For example, if the pandemic worsens, banks can lower their rates or purchase more bonds very quickly. In the status quo, however, it is not so easy. Some are unable to because the government has too much control over them. Some are roped to external costs that they have no control over. But even the most independent banks, like the Feds, take time to make decisions, so that they don’t cause recession.