Why are central banks raising interest rates?

All prices are going up: fuel, electricity, gas, fruit and vegetables, hotels and now interest rates too.

The war in Ukraine, successive lockdowns in China, ongoing energy shortages and disrupted production chains have fueled a strong appetite for goods and services, disrupting the delicate balance between supply and demand. This has caused prices to rise to record highs. Inflation, or the general increase in prices, is beginning to worry many governments.

Almost synchronously, central banks around the world are hastily raising their key interest rates in the hope of bringing runaway inflation under control.

For its part, the European Central Bank (ECB) has become one of the last institutions to change monetary policy, ending a long chapter of negative interest rates dating back to the worst years of the sovereign debt crisis.” “European Union .

Central banks in the UK, Sweden, Norway, Canada, South Korea and Australia have taken similar action in recent months in response to alarming inflation figures.

The US Federal Reserve (Fed) also raised interest rates by three-quarters of a percentage point on June 15th, the largest increase since 1994, in an attempt to control higher-than-expected inflation.

What is the economic mechanism that justifies such a decision?

A country’s central bank is primarily an independent body charged by the state with deciding how to apply monetary policy. In the case of the European Central Bank (ECB), it is a community institution representing the nineteen countries of the European Union that have adopted the euro.

These banks have the power to issue notes and coins, control foreign exchange reserves, act as emergency lenders, and ensure the health of the financial system.

The main task of a central bank is to ensure price stability. This means it must control both inflation – when prices rise – and deflation – when prices fall.

**Why do central banks decide to raise interest rates when it could slow down the economy? **

In general, low interest rates enable higher economic growth and thus lower unemployment. If, on the other hand, key interest rates rise, growth and employment fall because the economy is granted less liquidity.

For this reason, all central banks aim for moderate and positive inflation, generally around 2%, to encourage gradual and steady growth.

But when inflation starts to rise, the central bank is in big trouble.

In fact, too much inflation can quickly wipe out the gains made in the boom years, erode the value of savings and eat away at corporate profits.

Bills are getting more expensive for everyone: consumers, businesses and governments are all in trouble.

This is where monetary policy comes into play.“High inflation is a major challenge for all of us,” said Christine Lagarde, President of the ECB, during her June 9 press conference.

The central bank is the “bank of the banks”

Commercial banks, which we turn to when we need to open a bank account or borrow money, borrow money directly from the central bank to meet our most immediate financial needs.

Commercial banks must provide a valuable asset, called “collateral,” that accurately guarantees that they can return that money. Treasury bonds, the debt instruments issued by governments, are among the most common forms of collateral.

In other words, a central bank lends money to commercial banks, and the latter lend money to households and companies to support growth.

When a commercial bank repays its debt to the central bank, it has to pay an interest rate. The central bank therefore has the power to set its own interest rates, which in turn determine the price of money.

When the central bank imposes higher interest rates on commercial banks, they in turn increase the rates they offer to households and businesses that need credit to invest.

As a result, home loans, consumer loans and credit cards are becoming more expensive and households are becoming more reluctant to turn to financing organizations. Companies that need banks to invest in their future are beginning to think twice before acting. Hence the slowdown in the economy.

The results of economic policy do not come immediately

The tightening of financing conditions will inevitably lead to a decline in consumption in most sectors of the economy. When the demand for goods and services falls, their prices tend to fall.

That’s what central banks intend to do: cut spending to curb inflation.

However, it may take up to two years for the impact of monetary policy to be felt, so it is unlikely to provide an immediate solution to the most pressing problems.

Further complicating the situation is that energy is now the main driver of inflation, fueled heavily by an element not directly related to the economy: Russia’s invasion of Ukraine.

Gasoline and electricity are staples that everyone uses, regardless of cost, so a quick drop in demand at lower prices won’t be that easy.

Central banks like the Fed have taken drastic action, even if it could hurt the economy. Aggressive monetary policy is like walking a tightrope: making money more expensive can slow growth, lower wages and increase unemployment.

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