Inflation and the role of the Central Bank

Interest rates, inflation, central banks, all terms that appear new especially in this period when prices have risen very clearly. In this context, central banks play a very important role but their function is not very clear, especially for those who know little or nothing about the economy. In this article we will look at the role of the Central Bank within the economy and how this is the main responsible for the performance of the economic-financial system of reference.

The purpose of this article is to make it clearer what is happening around us in this historical period where inflation, i.e. rising prices, is significantly affecting our spending and savings.

What is a Central Bank?

The word itself says it, it is the most important bank that exists within the economic system. For example, in Europe the Central Bank is the ECB, in the United States it is called the Federal Reserve, in the UK it is called the Bank of England, in practice each economic area has its own reference central bank. Better to specify this thing, each currency area has its own central bank of reference, that is, each area that uses a certain currency has its own central bank.

The Central Bank has two tasks both of which are very important: the first is to "print" liquidity which will then be distributed to commercial and investment banks (ie banks as we know them), while the second task is to regulate growth and the stability of prices within the reference economy.

But what does it mean to “regulate growth and price stability”? Imagine a central bank that “prints” money endlessly. What can ever happen to an economy where there is infinite money? A huge amount of money would start circulating and prices would rise at an uncontrolled pace. The same thing could be said if a central bank stopped printing money altogether: the economy would freeze, no one would have access to credit anymore and as a result the whole economy would stop.

As you have seen with these two "absurd hypotheses" that the central bank must necessarily control its operations by means of fixed parameters that serve to keep the economy in equilibrium. Given the tasks of the central bank, we can say that its main objective is what is called "inflation targeting", that is, the central bank must ensure that the money it prints does not lead to imbalances in the economy and therefore each central bank has its own reference “target” for inflation (the growth of the price level) which in Europe and the USA is that of 2%.

In practice, the central bank has the task of bringing the price level to around 2% in order to make the reference economy sound. This is the main goal of a central bank, to regulate inflation.

How does it regulate inflation?

We said that the central bank "prints" money, let’s explain this concept better. Take for example the ECB, the European Central Bank, which is responsible for the trend in inflation and the money in circulation in the Euro area. The ECB prints the Euros that will be used by commercial banks for loans, mortgages and investments. The ECB obviously does not give money to banks, on the contrary, the latter will have to "pay" to have that money, money that is literally auctioned periodically, a competitive auction that will determine which bank will have the most money. The money will be paid by means of an interest rate, a cost that the banks will then “pass on” to the final consumers, that is, to those who request loans, mortgages and lines of credit.

The higher the interest rate, the more expensive mortgages, loans and lines of credit will be, so companies that ask for lines of credit will have to pay more, the products and services they sell will have to be more expensive, in short, if it becomes everything more expensive here is that the economy will tend to stall.

Now, we have introduced the concept of interest rate. As seen in the previous example, the higher the interest rate, the more inconvenient it will become to borrow money, leading to a lower circulation of money which inevitably leads to a decrease in consumption and therefore in inflation. In practice, the Central Bank regulates inflation via the interest rate, making the money it puts into circulation more expensive.

It is no coincidence that a synonym for "interest rate" is "cost of money". Taking another example, if the Central Bank sees that the economy is depressed, stuck and uninspired, it will make money cheaper so that it can stimulate demand and it will do so by lowering the interest rate. This explains the relationship between "interest rate" and "inflation".

The current situation

Attention, the Central Bank does not have full control over inflation but has only the liquidity that is injected into the economic system under control. Inflation is not directly controllable by the central bank, but the latter has an important influence on its performance. In recent years we have witnessed a very accommodative central bank policy, ie a policy that has seen central banks give liquidity to banks without seeing any effects on inflation.

But how was this possible? Quite simply, that liquidity did not go into the economic system as it should and was diverted to the financial markets which were much cheaper in terms of returns. In practice, commercial and investment banks, instead of injecting money into the economic system, have preferred to invest in the stock markets which certainly do not contribute in any way to the increase in inflation. In practice, a lot of liquidity in the financial system without increasing inflation, a truly uncomfortable situation.

As soon as the financial system saw its first block with the pandemic and then with the ongoing war, everything was unloaded on the economic system, causing prices to rise very quickly. Now, central banks have the sole task of blocking this rise by means of rising interest rates, which is happening. Given that inflation levels are well beyond inflation targets, one wonders where the mistake was. Well, looking at the results of the current economy, this situation was widely predictable and quite a few have raised doubts about the huge amount of money scattered within the financial system since 2010 with rates at 0%.

Where were the central banks? Are economists far-sighted and do they know what they are doing? Obviously not and the results are there for all to see. Unfortunately, the work of central banks at this time is questioned by the results we have in the economy and their "discharge of responsibility" on exogenous events such as pandemics and wars is not enough to justify the current economic situation.

Original article published on Money.it Italy 2022-11-03 08:57:00.
Original title: L’Inflazione e il ruolo della Banca Centrale