How Central Banks Use Monetary Policies To Handle Inflation

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Source: Mikael Blomkvist via Pexels
Source: Mikael Blomkvist via Pexels

Inflation occurs when an increase in the quantity of money leads to a general rise in prices, or the growth of the money stock in an economy increases faster than the level of productivity. Central banks pursue different monetary policies to safeguard against inflation whenever it occurs. In this guide, we look at the financial policies of central banks in response to global inflation trends.

How Do Monetary Policies Work?

Central banks use monetary policies to manage economic fluctuations like inflation and achieve price stability. They focus on keeping inflation low and stable by setting inflation targets. Monetary policies adjust the money supply by buying and selling securities in the open market. They can also increase or decrease the interest rates, which shows that the policy is tightening or easing up.

Central banks started using monetary policies to reduce interest rates after the 2007 global financial crisis. They also bought long-term bonds to reduce the rates and took short-term rates below zero. Again, during the COVID-19 pandemic, central banks used foreign exchange interventions, asset purchase programs, and other monetary policies.

Current Global Inflation Trends

The global inflation in 2023 reached 6.9%, one of the highest annual increases since 1996. This was due to compounding issues like rising food and energy prices, consumer insecurity, and the instability left in the wake of the pandemic.

Global inflation rose from 4.7% in 2021 to 8.8% in 2022 but declined in 2023. It is expected to decrease further in 2024 to 4.1%. But it’s safe to say that this is the weakest growth profile except for the global financial crisis and the COVID-19 pandemic.

Central banks are increasing their rates to fight inflation and withdrawing fiscal support due to high debt levels. Inflation also falls faster in most regions due to restrictive monetary policy and supply-side issues.

Monetary Policies of Major Central Banks to Inflation

Source: Isaac Smith via Unsplash
Source: Isaac Smith via Unsplash

Central banks’ main monetary policy to control inflation is inflation targeting. Modern central banks set a target for the inflation rate as the primary metric. If the prices increase faster than the target, they tighten the policies by raising interest rates. This leads to more expensive borrowing, less consumption, and fewer investments. With currency changes in different countries, investments like forex trading are affected.

On the other hand, if inflation falls below the target, the interest rates will reduce, borrowing will become cheaper, and the central bank will implement other expansionary policies. Central banks usually set an inflation target of 2–3% and use policies to remain within their target. Some monetary policy tools central banks use in inflation targeting include discount lending and open market operations.

Central banks also have to influence the money supply to control inflation, but modern governments hardly ever print and distribute money to do this. Instead, they use controls like interest rates for interbank lending. By implementing interest rate adjustments, central banks can control an economy’s borrowing, saving, and spending levels.

Central banks can manipulate interest rates to increase or decrease the demand for goods and services. But, the impacts of monetary policies are often delayed and difficult to evaluate. Central banks often adjust their policies to respond to inflation dynamics and changing economic conditions.

Major Central Banks’ Monetary Policies

Aside from inflation targeting, there are other policies used by different central banks to control inflation. More advanced governments use inflation targeting and other strategies to enhance their control of inflation dynamics.

The Federal Reserve of the United States mainly analyzes its interest rate decisions, forward guidance, and quantitative easing programs. As for the European Central Bank, they often focus on interest rate policies, asset purchase programs, and communication strategies. In Asia, the People’s Bank of China also uses interest rate changes, assesses reserve requirements, and performs liquidity injections. And in Japan, the central bank uses inflation targeting, yield curve control measures, and asset purchases.

Despite these geographical and strategic differences, the common goal of central banks is to maintain price stability and support sustainable economic growth. They must balance inflation objectives with macroeconomic goals like financial stability and employment.

Impact of the Monetary Policy on Financial Markets

Source: Mikael Blomkvist via Pexels
Source: Mikael Blomkvist via Pexels

Monetary policy plays an essential role in influencing economic growth through different channels. The central bank needs to control the level of money supply through maintaining price stability. They can keep inflation low and stable.

While advanced countries have explicit inflation targets, developing economies are also moving towards inflation targeting. The positive effects of monetary policy on the economy include decreased unemployment, simulated economic growth, and currency devaluation.

Future Outlook of Central Banks’ Monetary Policies

Based on the current global inflation trends, the future outlook of the monetary policies of central banks is affected by numerous factors like inflationary pressures, evolving economic conditions, and geopolitical developments. As inflation trends strike economies, central banks will closely monitor inflation trends to check if recent increases are transitory or indicate more persistent price pressures. Ultimately, the inflation trajectory also influences the timing and magnitude of future policy adjustmen

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