Why are central banks worried about inflation

How does the European Central Bank ensure stable prices?

It is not easy for the European Central Bank. It is supposed to ensure stable prices in Euroland - according to Article 105 of the Maastricht Treaty it is obliged to do so. And after all, this is an international treaty with constitutional status, which can only be changed by a unanimous vote of the Council of the European Union, by the consent of the European Parliament and by ratification of all national parliaments involved.

It was not easy for the Deutsche Bundesbank to ensure stable prices and contain inflationary trends. Because even in Frankfurt or Munich the price level is different than in rural areas such as Lower Saxony or the Pre-Alps - the currency area, in which the European Central Bank has observed different price trends, has become much larger.

But what exactly is inflation? It would be ideal if the consumer price index at the end of the year were at the same level as at the beginning, i.e. the annual inflation rate was zero. But central bankers are pragmatists and not idealists. They assume that an economy will still function without tension when prices rise by an average of two percent a year. The patient only has to go to the operating table when there are dangers on the horizon that will permanently miss this mark.

A central bank's toolkit is quite extensive. For example, it can observe exactly how much money is available to economic agents and try to control this amount of money. The idea behind this is that the production potential of an economy and its people must be matched by exactly a certain amount of money in order to ensure inflation-free growth. If the money supply grows faster than the production potential, the economic agents get the impression that they are richer than before. With this illusion of money, they want to buy more goods, which drives up demand and thus prices. If, on the other hand, the economy is insufficiently supplied with money, this inhibits inflation, but the scarcity of money then also increases the interest rate, the price of money, so to speak. That means less investment, consumption and growth - the trouble with the politicians is inevitable.

But how do you control the growth of a money supply? If it grows too quickly, we stop the money printing machine, and if it grows too slowly, we make it run faster, the obvious answer might be. Unfortunately, the reality is a little more complicated. The central bank is the only institution that is allowed to produce money and put it into circulation, everyone else must expect to be in prison sooner or later. But in 1999, for example, the currency in circulation in Euroland was around 330 billion euros, the actual money supply, on the other hand, was the proud sum of 4,500 billion euros, i.e. 13.6 times more, without anyone having to go to jail for it.

This is because the banks are also involved in the money creation process. In the past they had thick account books, today they have thick computers in which every claim and counterclaim, every credit balance, every savings account and every bond is meticulously recorded. Because such claims and balances can be converted into cash at any time, they must also be added to cash. The fact that these monetary claims and balances exceed the actual cash holdings several times over is not criminal, but quite legal. Since not everyone withdraws all of their credit balance in cash, it is sufficient to only cover part of it in the form of cash. The rest is so-called deposit money. Directly controlling the growth of this giral money supply is particularly difficult. The US and UK tried and soon gave up. The Bundesbank also failed eleven times in 21 attempts to keep the growth of the money supply within a certain target range.

One of the reasons for this is that the central bank does not alone determine the growth of the money supply. The behavior of investors, commercial banks and governments also have an impact on this quantity. That is why the European Central Bank relies not only on analyzing the development of the money supply but also on a second pillar, the observation and analysis of all economic and financial indicators that can give an indication of future inflation risks. This can easily lead to contradictions or even a dilemma, for example when the money supply concept, the first pillar, and the indicator concept, the second pillar, refer to different periods of time and therefore give different signals. For example, what should bankers do when the short-term indicators signal a decrease in inflationary pressure, but at the same time the money supply threatens to get exorbitantly out of hand in the medium term? For example, this could lead to a tendency not to do anything for the time being, even though measures to curb the impending inflation would have been appropriate for a long time.

Most economists say that it is important to communicate clear intentions to the markets that are unmistakably clear. Monetary policy should be open, honest, transparent and consistent in order to be credible. Markets should not be left in the dark about goals. The goals and decisions must be clearly communicated. If the ECB shows, for example, by taking concrete measures that it is not prepared to accept an inflation rate higher than two percent in the long term, there is no uncertainty in the markets about the future course of the central bank, and the inflation expectations of market participants are stabilized at a low level .

The real weapons in the fight against inflation are interest rates. A central bank does put money into circulation, but it doesn't give it away. Every week it auctions central bank money to commercial banks on deposit of fixed-income securities, but not for free. The commercial banks have to pay interest for it. This interest rate is called the main refinancing rate and is the most important key interest rate in Euroland. If a money buyer at the bank has miscalculated and realizes that his bank needs more money for processing daily business, his bank can obtain more money at short notice from the ECB by depositing additional securities - albeit at higher interest rates, the so-called Marginal lending facility.

Finally, the third key interest rate is the so-called deposit facility. If a bank notices that it has borrowed too much central bank money for its day-to-day business, it can invest this money in central bank accounts overnight - at a meager interest rate that prevents the banks from suddenly throwing money around and the money market rates press down. The banks, in turn, make central bank money available to the economy and households in the form of loans. The interest rates are based on the key rate of the central bank, plus a margin for the bank to pay the employees, the light and the rent and to keep the bank's shareholders happy. In this way, the key interest rate of the ECB has a direct impact on the interest rates of the entire economy. This gives the central bank an influence on whether the money is "cheap" or "expensive" - ​​what is meant is the interest rate at which you can get it from the banks.

If the central bank raises the key interest rate too sharply in its efforts to fight inflation, it could potentially stifle economic growth. The opposite case, with low interest rates to stimulate the economy, carries the risk of rising inflation. Therefore, under the Maastricht Treaty, the European Central Bank is only obliged to ensure stable money - that is, low inflation. Stable money creates the best conditions for healthy economic growth. Politicians and companies have to ensure that things come to that point - even if some politicians like to use the ECB as a scapegoat for a failed economic policy.