What do central banks do?

Marcello asks:

What are the pros and cons of the fed raising the interest rates? How does it help control inflation?

I’ll begin by describing the main goals of financial regulation and central banks before turning to the relationship between inflation and interest rates and the Federal Reserve’s tasks.

In theory, financial regulation, like any regulation, is meant to improve market efficiency and reduce systemic risk. In most cases, this means promoting transparency, spreading accurate information promptly, and preventing fraud and mistakes that put the entire system at risk. In reality, these goals tend to be ignored by politicians who want big banks (“national champions”) or benefit from bribes and (retirement) jobs at banks that they allow to make excess profits by taking risks at taxpayers expense (“privatize the gains, socialize the losses”) or growing “too big to fail.” In the US, the biggest problems arise from dividing regulation among so many government agencies that it’s ineffective and the ongoing subsidies to FannieMae and FreddieMac, the private-profit, government-guaranteed mortgage buyers at the central of the Financial Crisis of 2007-12.

Central banks sometimes regulate banks (and other non-bank financial firms), but they are always in charge of managing the money supply with the goal of “keeping inflation under control,” which has been codified as “near 2 percent” for historical reasons.

The connection between inflation and interest rates is tricky, so let me say a bit more about inflation, interest rates and the money supply.

First, there are two types of inflation. “Supply-push” inflation reflects the supply of money. As a simple example, start with a money supply of 100 and 100 units of goods sold at an average price of 1.00. In this case, the price index is 100 because the average basket of goods costs 100 units of money. If money supply doubles (everyone has $2 for every $1 in their pockets), but there are still 100 units of good, then the price index doubles to 200, meaning that inflation is 100 percent. (The most familiar price index — the Consumer Price Index, or CPI — is often used to measure inflation.) Supply-push inflation is present in Venezuela because the government is printing money — and lying about it with the hope that citizens will not notice — while the supply of goods is falling (big topic for another post).

“Demand-pull” inflation results when people devote more of their spending to some goods and thus less to other goods. In most cases, this inflation is normal and benign, because it increases profits in that sector and thus attracts more supply (resources arrive from shrinking sectors), but various political-economic distortions might lead to harmful sorts of demand side inflation in, for example, higher education, medical care and housing in the US. I could write a whole book on these issues, but I’ll give you the simple example of housing markets where demand is strong (people are moving to the area or buying larger houses because they are wealthier) but building regulations restrict demand.

Interest rates can be used to raise and lower inflation by making money “more expensive.” If inflation is high, then an increase in interest rates means that it’s better to save rather than spend money because you can make more money by leaving the money in the bank or investments. This reduction in the “velocity of money” means that they are fewer people chasing the same number of goods, so prices of those goods slow or stop rising.

Interest rates are often set in markets for money based on the demand of a country’s currency vis-a-vis other countries or the money supply set by central banks. It is for these reasons that interest rates depend on exchange rates, banking reserve requirements, open market operations (buying and selling bonds) and many other factors that are hard to understand, let alone manage. It’s this complexity that lies at the heart of debates over the role of central banks. Some people think that central bankers are geniuses that manage our collective prosperity. I am with the other people who think that humans introduce more noise and prefer that a bot increase the supply of money at a known rate and leaves the market to sort out the other factors. (Bitcoin was released 10 years ago based on that exact logic. If you’ve followed its price gyrations, then you know that other factors affect its demand and thus its price!)

Also note that interest rates vary by maturity (e.g., interest rates on overnight deposits vs 30-year loans) because varying “time preferences” lead to different aggregate demand functions.

This summary should give you a (vague) idea of how regulations are supposed stabilize prices and markets, but a brief look at the macroeconomic performance of 200+ countries will tell you that politics, regulations and cross-border operations combine in unpredictable ways to produce systems that fail often, systems that fail when shocked and systems that affect others due to their size or reliability (i.e., the US, EU, China and Japan).

It’s my opinion that the greatest threat to financial and non-financial markets arise from political interference (e.g., India, Turkey, China, UK, Italy and the US in recent months). In many cases these are caused by populists who think that markets can be manipulated to suit their superstitions. They are sometimes right in the short run but always wrong in the medium (1-2 years) and long run. (I think that bitcoin and other “trustless” currencies might gain value in the near future as people lose faith in populist shenanigans.)

Finally, let me note that the US Fedeal Reserve in unusual in its dual mission of simultaneously keeping maximizing employment and preventing inflation. Although its hard to optimize on two margins, it’s even harder to pursue these goals because increases in employment eventually lead to increases in wages (as the supply of workers falls short of demand), which leads to demand-side inflation and thus the need to increase interest rates, which will cool the economy and thus dampen demand for workers.

So what are the pros and cons of increasing interest rates? A reduction in economic activity and job losses (cons) but a decrease in prices and inflation (pros).

My one-handed conclusion is that markets are hard to “manage,” and thus should be regulated in a slow, incremental and transparent way. Most economists understand this. Few politicians do.

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

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