Who protects us against inflation

If both high inflation and deflation are detrimental to citizens, it is easy to see that the ideal scenario for the economy is low, stable and predictable inflation. So how can we make sure that is the case? Who is in charge?

The answer is central banks, which are tasked with keeping inflation and deflation in check, and maintaining price stability through their monetary policy.

Inflation, central banks and monetary policy: disease, the physician and medication

If excessively high levels of inflation or deflation are a disease for our economy, the central bank is the physician we turn to, and monetary policy is the medicine which provides the therapy.

The European Central Bank (ECB) has set an inflation target of 2 per cent over the medium term. Our physician treats inflation as if it were blood pressure: if the pressure is too high, it must be lowered to prevent the risk of a heart attack; on the other hand, if the pressure is too low, the patient will not be able to get out of bed. Both situations - too high or too low a pressure - must be avoided, as is the case with high inflation and deflation.

Monetary policy works as a drug or a supplement that helps regulate blood pressure.

Through monetary policy, a central bank makes decisions that influence the cost and availability of money in an economy. It normally does so by using specific instruments, known as 'key interest rates'. By raising these rates, the central bank seeks to influence all other interest rates, including those applied by commercial banks to medium- and long-term loans to their customers. This makes borrowing money less affordable, as mortgages and other loans are more expensive. Furthermore, people will save more, as interest rates rise on money kept in accounts and other saving instruments. Therefore, household spending and business investments decrease. There is a decline in demand, and consequently, in price growth. An increase in interest rates can also influence consumer and business expectations about future inflation (inflation expectations).

Conversely, if inflation is too low or there is deflation, the central bank reduces interest rates to foster consumer and business demand and help the prices of goods and services grow. 

An effective drug for the treatment of inflation? Raising interest rates!

There is an inverse relationship between the increase in interest rates and the inflation rate. An increase in interest rates hinders demand and economic growth and may lead to a rise in unemployment (the drug's side effects), whereas a decrease in interest rates furthers growth in demand, in the economy and in employment. Demand will exceed supply and then prices will rise. Although there are many ways in which interest rates can affect inflation (transmission mechanism) and some of them have uncertain outcomes, raising interest rates is the main monetary policy instrument when it comes to containing inflation. Conversely, decreasing interest rates is the tool used to foster demand and economic growth and generally to increase prices. When interest rates are raised, we talk about restrictive monetary policy and when rates are lowered, we talk about expansionary monetary policy.

Although the main instrument of monetary policy is altering interest rates, central banks have more recently implemented a new measure that directly affects financial markets. By buying and selling bonds, a central bank can influence the trend of longer-term interest rates. It is the same principle: higher rates cool the economy and therefore inflation, and lower rates stimulate the economy and bring inflation back up to the desired level.

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