It’s easy to forget that, actually, before the pandemic, most central banks struggled to get inflation above this line. But now,
following global lockdowns, unprecedented US stimulus and a war in Ukraine,
inflation is far FAR above target.
It’s at 8.6% in the US, 8.1% in the Eurozone, and a whopping 9% in the United Kingdom.
So, central bankers have now basically said: enough is enough. Or as U.S. Federal Reserve chairman Jerome Powell so passionately put it:
(see clip)
it is essential that we bring inflation down
And with surprising confidence he added:
“We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses
But, is that true? First, they couldn’t get inflation above target and now its far above it. In other words, do central bankers actually have the tools to control
billions of prices, set by millions of interacting households and firms?
Well, to answer that question, let’s have look at
these supposedly powerful central bank tools and how central bankers think they can crush inflation in our massive, decentralised economies.
Jerome’s Powerful Tools
Okay, central banks plan to crush inflation with not just one, not two, but three main tools
- The first tool is the interest rate that they charge banks,
today the federal open market committee raised its policy interest rate by three quarters of a percentage point
This is the traditional and most well-known tool of monetary policy. With raising the policy interest rate, Mr. Powell means that the both the interest rate which the Fed charges banks that borrow reserves and pays banks that deposit reserves has just gone up.
Typically this means that banks will also start charging higher interest rates to borrowers and paying higher rates to savers.
- the second tool is telling us what central banks intend to do with their interest rate in the future
and anticipates that ongoing increases in that rate will be appropriate
And to make it more precise, Mr. Powell then told us that
the appropriate level of the federal funds rate is 3.4 at the end of this year
In central bank jargon telling us what interest rates will be is known as forward guidance.
This is a really powerful tool that you rarely hear about, even though central bankers see it as being crucially important.
After all, the worth of financial assets such as stocks and bonds comes from what profits they can generate in the future.
So, the financial assets will not just react to what interest rate do today. But, also to what they will likely do in the future.
Now, I know this one sounds a bit tricky. And so, it’s really easy to miss it.
But, if you do, financial market reactions to central bank announcement will often catch you off guard.
For example, after this specific announcement by Powell, stock markets immediately went up.
This caught a lot of people off guard because the immediate rate hike was higher than expected.
However, because the path towards these rate hikes was slower than expected the market was still pleasantly surprised.
- Now, the third and final tool that the central bank will use to crush inflation is their balance sheet
in addition we are continuing the process of significantly reducing the size of our balance sheet
This is also known as quantitative easing if central banks increase the size of their balance sheet and quantitative tightening if they decrease it.
So, central banks are selling some of the assets they hold on their balance sheets. This means that they increase the supply of long-term assets in the economy… which also raises the interest rate on these types of longer-term assets
So, in the end its really not that complicated.
Central bankers plan to crush inflation by raising the bank interest rate now, by indicating that they will raise it more in the future, and by raising long-term rates indirectly through quantitative tightening.
But, then, to understand how exactly we get from these increased rates to inflation, we first need to understand how inflation comes about.
Inflation Refresher
Okay, the way that central bankers think about inflation is that it can be caused
by either too much demand or not enough supply.
When it comes to inflation after the pandemic, central bankers still think that most of it was caused the massive impact of global lockdowns.
On top of that, Russia’s invasion of Ukraine has caused massive energy and food supply problems.
But, central bankers also stress that while inflation is much
too high the US, Euro Area, and UK,
the main drivers of inflation in each area are now quite different.
I think that Bank of England governor Andrew Bailey summarized this view quite nicely when he said:
The United States is facing what looks like a demand shock.
In all seriousness, what he means by this is that
while there has also been a big supply hit in the USA, there has a been a particularly big increase in demand in the USA due to stimulus checks. This has created extra purchasing power and hence more demand.
This had pushed U.S. inflation above that of Europe initially.
However,
The Euro Area by contrast is facing a supply cost shock as it starts with a somewhat weaker domestic labour market and it’s heavily exposed to the rising gas prices.
This loosely translates to,
European inflation is now also really high because it is heavily exposed to gas prices which are being pushed up by the war in Ukraine.
He also says that
In the UK, we are seeing elements of both
So, okay, inflation is caused by
massive supply chain disruptions everywhere, too much demand in the USA, and heavy reliance on Russian gas in Europe.
In other words, not by
the actions of central banks themselves.
And that is actually pretty strange, right? Because if they didn’t cause inflation, how are they supposed to stop it by raising interest rates?
In other words, how do changes in the various interest rates impact inflation?
Monetary Transmission
As you have seen,
an economy consists of millions of households and firms, as well as different asset markets and banks.
You might not be surprised that economists have come up with a lot of ways that
central bank policy rates, forward guidance, and quantitative tightening can potentially influence inflation.
But, most economists agree that increasing interest rates with any of these tools tends to
reduce demand in the economy by influencing the financial sector first.
After all, even though it is very tempting to talk about central bank money printing creating demand, that is just not how the system works. After all, regular people like you and me do not have an account at the central bank.
But, since most commercial banks do pass-through higher rates, central banks can indirectly make borrowing less attractive, and hence reducing money created by private banks.
What’s more, higher interest rates make risky assets less attractive compared to safe ones
and therefore will make their prices go down.
Well, that first part of the transmission mechanism seems to be working.
But, then how are reduced borrowing and decreasing asset prices supposed to decrease demand?
Well, high bank rates might mean fewer credit card purchases and thus less demand for goods & services. What’s more it might mean less loans for companies, which might go out of business and fire a lot of their employees. This might then mean that wages are less likely to rise and therefore prices are less likely to rise.
What more, lower asset prices mean that people will feel poorer. And that might in turn mean that they will spend less money on goods and services. What’s more, lower stock valuations, could also mean that companies are less willing to invest and thus will hire less people.
Well, that second of the transmission mechanism also seems to be working.
Finally, central bankers believe that it might be possible that expectations about inflation actually cause inflation without doing anything to supply or demand.
You see, if firms expect inflation they
might raise their prices.
And if workers expect inflation,
they might demand to be compensated in advance.
And, by acting firmly now, the central bank hopes to temper those expectations which will re-enforce the demand effect.
Now, it is important to note that precisely because the economy is so complex, and data about behaviour is difficult to capture, there is no scientific consensus on which of these channels is the most important.
Still, most economists agree with central bankers that interest rate hikes decrease demand and therefore tend to bring inflation down.
Final thoughts
So, it’s clear that in a decentralised economy, such as the ones that we all live in, Central banks aren’t fully in control of inflation.
They cannot control pandemic related supply chain issues and they can’t control demand generated by government spending.
However, they do have three important tools to influence inflation and these primarily work by reducing demand.
Or…. if you want to put in a somewhat more controversial manner,
by trying to make people poorer and get them fired.
This has let some people to rightfully criticize central banks for manufacturing a recession.
But, I do think that economist that are right to point out that there is genuinely a scenario in which the central bank increased rates by just enough. Alternatively, they could just lower interest rates again if a recession is immanent.
In that scenario demand will decrease and some people will loose their jobs. But, inflation will decrease more. Therefore, people will be better off on average.
But, with sky high asset prices everywhere and a lot of that being built on mountains of debt, this will be an extremely tricky balancing act.
Sadly, given its complexity, there simply is no certainty in macroeconomics.
Making it even more important to subscribe to the channel to keep up to date on the latest developments. Or, if you want to discuss this and other issues in a small discord server with me and others, consider becoming a Patron or member using the links in the description.
Finally, if you want a deeper dive into what caused initial inflation check out this video over here, or if want to know more about why, in this case, quantitative easing was not to blame for inflation, check out this video over here.