0
$\begingroup$

We hear in so many places that the current high levels of inflation are mainly due to supply side problems, like the war in Ukraine. Given that there is currently less supply then we are all inevitably going to be less well off in real terms. So why are central banks raising interest rates to "fight inflation"? The central banks can not shield the population from the inevitable drop in living standards. What do they think they can achieve?

$\endgroup$
1
  • 1
    $\begingroup$ Life is full of mysteries. Why do chefs cook at restaurants? Why do musicians play concerts? Let us not forget about the biggest mystery of them all, why does an organization set up to keep inflation low worry about high inflation? Why would central bank think they need to do something about inflation? Such an arcane mystery. Mind boggles, I don't think even Bernanke would be able to crack this mystery. $\endgroup$
    – csilvia
    Nov 3, 2022 at 16:15

3 Answers 3

3
$\begingroup$

It's a common misconception that central banks fight, or need to fight, current excess inflation. They don't, and they can't. It's already here and too late to do anything about it and real incomes are hit. However, central banks can do something about future inflation.

Indeed, there is a link between current and future levels of inflation. The longer high inflation lasts, the greater the chances high inflation persists into the future unless the central bank can successfully intervene. Current high inflation levels may translate into employees asking for wage increases, and higher input costs (wages and other input prices) may underpin future inflation, and so on.

So, central banks are targeting future medium-term inflation, not current inflation. Although it's not always explicitly stated, it's implied by how inflation and monetary policy work, the latter taking several quarters to develop its full impact. For central banks mandates, see, here for the Fed and here for the Bank of England.

A key element in these efforts to achieve medium-term inflation close to the target is to manage inflation expectations, based on which businesses set prices and wages are negotiated between employers and employees (among other things). By raising policy rates, central banks signal to the public and the markets their commitment to controlling future inflation, thereby already curbing inflation expectations if successful. Higher policy rates also act to cool down future economic activity directly by generally tightening financing conditions, which in turn reduces inflationary pressures on future prices, other things equal, helping to bring inflation back to target.

Note that central banks are aware that they are inflicting additional harm in the near term when they raise rates. However, they argue that the benefits of having low and stable inflation in the medium term as a result of these hikes outweigh the short-term pain.

$\endgroup$
2
$\begingroup$

Not sure about the source of your information, supply bottlenecks have not completely eased yet (E.g. China zero Covid policy). Also, inflation is not only/mainly (goods-)supply-side related : E.g. Money was made very cheap during the pandemic, labour markets being buoyant owing to fierce demand for labour after a brutal shutdown of the economy.

One of the mandates of a central bank is to avoid inflation spiralling (inflation feeds more inflation) . Again, this is a multi faceted-issue, slowing down the economy by increasing rates will soften demand which in turn is supposed to bring down inflation. Central banks walk on a tightrope between killing growth and protecting society from inflation (especially because the effect of hiking rates takes time to show symptoms in the economy), let alone their credibility.

Hiking/cutting rates is just one tool in the monetary policy toolbox.

An interesting basic study case is Turkey where the central bank is not raising rates, inflation reached 80%.

$\endgroup$
1
$\begingroup$

So why are central banks raising interest rates to "fight inflation"?

Central Bank's sole job is to fulfil their mandate, CB is not supposed to follow other goals than the ones in the mandate. Two major world's central banks are ECB and Fed.

ECB has sole mandate to keep prices stable which they interpret as average inflation being close to 2% (see ECB). So ECB has to keep inflation at around 2% regardless of what effect it will have on consumers. That is simply inconsequential to ECB.

Fed has dual mandate that requires Fed to (see Fed):

maximum employment, stable prices, and moderate long-term interest rates

The maximum employment is defined as employment at which inflation is not accelerating (see Brookings explainer).

Currently, it is accepted that US is at or very close to maximum/full employment (see WSJ) so Fed managed to fulfill that part of a mandate and only unfulfilled part is to have stable prices.

Most CB's around the world have mandate that either is similar to ECB or similar to Fed.

What do they think they can achieve?

They think they will achieve their job, which is too keep prices stable. Central bank's job is not to pursue some broad measures of well being. Their job is to follow the mandate they have been given.

$\endgroup$
5
  • $\begingroup$ Why is ECB choosing to keep interest rates far too low for current inflation levels? They should be raising faster, based on their mandate, since they have nothing else to consider. $\endgroup$ Nov 3, 2022 at 16:55
  • 1
    $\begingroup$ Since eurozone inflation is 10%, interest rates should also be above 10% to end inflation. This would also cause about half the eurozone countries to default, leading to mass riots and starvation in the eurozone, but preventing this is outside the mandate of the ECB. $\endgroup$ Nov 3, 2022 at 17:05
  • $\begingroup$ @user253751 because they define price stability as 2% inflation per year. 0% inflation is equally bad for ECB as 4% inflation. ECB is not supposed to care about whether countries default or not, if they do they are acting contrary to the EU law like police officer doing vigilantly work after hours. I do not think there is any evidence though that they care about countries defaulting. There would be lower probability of default if they kept interest rates negative. Why not just always keep them at -0.05% forever if they care about severing defaults? $\endgroup$
    – 1muflon1
    Nov 3, 2022 at 17:22
  • $\begingroup$ During great recession ECB raised interests too quickly and virtually all academic economists scolded ECB for that and it caused double dip recession. Ever since ECB conducted its policy scared to repeat the same mistake they did. But they still have mandate to follow violation of which is violation of EU law. $\endgroup$
    – 1muflon1
    Nov 3, 2022 at 17:26
  • $\begingroup$ @user253751 based on what model did you arrived at conclusion that 8% interest rate would keep inflation at 2% long term? Unless you support that number by something its arbitrary number. Why not at gazillion %? ECB uses various models to determine what optimal i should be plus they exercise some discretion, they can make mistakes and their models can be wrong but to discover mistake you first need to know what the correct i should have been. Pulling random number out of hat is nonsensical. Edit: this was response to now deleted comment "okay then, 8%. Actually 8.7%" $\endgroup$
    – 1muflon1
    Nov 3, 2022 at 17:27

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.