Why central banks?

I’m always astonished by how a change that is not visible nor tangible and is over and above minimal can make the headlines. But it always works. This week, for example, in the New York Times: “Fed Makes Biggest Interest Rate Increase Since 2000 as High Inflation Persists.

What had happened was neither more nor less than that the central bank of the USA (called The Federal Reserve) raised its key interest rate from 0 to 0.5 per cent. It doesn’t really sound like big news, does it?

But maybe it is.

Why did the central bank act like this? What will be the effect of this? And what does “key interest rate” actually mean? – Some basic remarks.

A central bank provides society with money. It prints banknotes, mints coins, and is increasingly giving away its money also digitally. 

Most countries have established a monopoly on money. This is convenient since everybody is then using the same currency.

However, how does the money get distributed among the people? Here the key interest rate joins the game. The central bank lends its money at a certain price – the key interest rate. 

If a central bank wants more money to come into circulation, it lowers the key interest rate; if it wants to tighten money, it increases the key interest rate, making borrowing more expensive.

By the way: Customers of the central banks are usually not private individuals but banks, which in turn bring the money into circulation themselves. Because banks lend themselves, their lending affects the amount of money in circulation as well, which can affect inflation (but that’s a different story).

Back to central banks. With the help of the key interest rate, central banks try to regulate inflation. From here, however, things get a bit complicated.

The point is, there are different types of inflation (I have written about all the six types here). If inflation is caused by having too much money in circulation, then the obvious thing to do is to correct the money supply by raising interest rates. 

This is the case, for example, when over time, the money supply increases faster than the amount of goods and services produced. Then, simply put, there is more money (and thus demand) than there are goods and services (supply). As a result, suppliers will raise their prices until all of their products are just bought by the customers. Supply and demand are then balanced again. If the central bank wants to break inflation earlier, it will reduce its money supply by raising its interest rate. 

However, the current inflation is not mainly driven by an oversized money supply. Prices rise across the board (which is nothing but inflation) because supply is tight and demand is high. 

In that situation tightening the money supply does not seem to be the appropriate remedy. But the central bank has no other means. So the central bank raises the key interest rate, therefore borrowing money gets more expensive. Subsequently, there is less investment, the economy is cooling down, and the price increase is slowing down. In this case, breaking inflation comes at a price: Fewer goods and services will be produced. 

So there are good reasons why a change in interest rates regularly makes the news. 

A final remark. 

Making it into the news with an interest rate decision is also crucial for a central bank. The reason: Inflation arises significantly from the expectations of inflation. 

If people expect inflation, they will adjust their own price expectations. Unions will then demand high wage settlements, and companies will adjust their prices to the expected inflation. The result: the assumption of inflation only leads to inflation.

Therefore, the central bank needs to signal that it is doing something about inflation. If many believe that the activity will be successful, it will be successful. But possibly less because of the activities of the central bank itself, but because of the people’s behaviour as a result of the central bank’s actions.

That’s a bit weird, isn’t it?

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