How monetary policy works
Interest rates are a central bank’s primary tool to impact economic conditions within a country. Through its use of open market operations, a central bank can effectively set a country’s interest rate, having a direct and indirect impact on a country’s economy.
In the short term, a change in the interest rate directly impacts the domestic return of a given country. Changes in these rates therefore influence the exchange rate of a currency, leading a currency to appreciate if the interest rate in that economy increases, or vice-versa if the interest rate decreases. These changes then alter the country’s purchasing power of foreign goods, which will in turn affect the prices of these goods.
Alterations in the interest rate also affect the interest rates which banks charge consumers, such as mortgage rates or credit card rates. Further, interest rates also have an impact the value of money and the price level of assets. These changes in turn will influence the supply and demand of goods and labour within an economy. Changes in the equilibrium of either of these markets will directly shift the price level within an economy, affecting both wages and domestic prices.
Along with these short-term impacts, changes in a country’s interest rate impact investor expectations as the profitability of future endeavours will change depending on the expected direction of the interest rate. For instance, lower expected inflation rates make it cheaper to borrow funds for a project in the future, leading investors to delay investing until these lower rates are realised. This in turn implies that profits will be expected to rise in the future, leading labour and capital to delay wage increases.
There are, however, certain types of shocks over which a central bank has no control. The most significant of these shocks include important changes to the global economy or changes in fiscal policy within a country. These changes can further be compounded by increased uncertainty within that country, which impacts investor expectations. Other external changes include changes in risk premia, changes in commodity prices, such as through new developments in technology, and changes in bank capital, which may be the result of new bank regulations.
With its aim of achieving price stability within the euro area, the ECB strives to ensure that inflation does not exceed the ECB’s target of near, but close to, 2% inflation over the medium term.
As high levels of inflation dilute a person’s real income and their purchasing power, ensuring price stability is a vital aspect of a prosperous economy. As a result, the ECB will react to changes in the European economy by wanting to stimulate or lessen inflation.
Historically, the ECB would use conventional monetary policy to influence inflation by setting interest rates. For instance, to increase inflation the ECB would cut interest rates, stimulating the economy. This is usually done by buying government bonds, which increases an economy’s money supply. However, as has been witnessed since 2008, these tools may not always be effective. Another way to influence inflation is through quantitative easing, where a central bank purchases commercial assets.
The effects of these policies may not always materialise immediately. Consumers take time to adjust to new interest rates, creating a lag between monetary policy and inflation.
Further, inflation can either be measured as “Headline Inflation” or “Core Inflation”. The former includes all goods within an economy, while the latter excludes goods with volatile prices, such as oil. Core inflation can therefore provide a more accurate measure of a country’s long-term price level.
The ECB focuses on achieving its target by measuring headline inflation. While the ECB’s target is arbitrary, setting a clear inflation target allows investors to adjust their expectations.