During 2022 the inflation rate has increased very rapidly in many countries. In response to this event, the ECB, inter alia, has increased the interest rate generating some protests and contrasting opinions. 

The inflation rate increase has been caused by many macroeconomic and geopolitical factors: among others, the Russian-Ukraine war, the economic recovery after the covid-19 crisis and the low interest rate since the sovereign debt crisis. This increase in interest rates is a natural response by the European Central Bank to a high inflation rate, nonetheless the process through which it influenced the inflation rate is highly complicated. In this article, I’ll try to analyse how the ECB transmits its monetary policy. 

First, it is important to spend a few words concerning the ECB’s goal for inflation. The European Central Bank commits to maintain a 2% inflation rate in the mid-term, allowing a small fluctuation in the short-term. The considered parameter is the HICP (Harmonised Index of Consumer Prices). The question “Why not a 0% inflation rate target?” might naturally arise. However, there are many reasons for keeping a positive inflation rate, as opposed to a neutral one. Consumer price indices tend to overestimate actual inflation: indeed, an index is the weighted average of the goods’ prices in a consumption basket. By keeping the weights constant for various categories of goods, changes in consumption habits are not considered, while consumers tend to substitute goods whose prices are growing faster with others that are more stable or less expensive. Hence, if the inflation rate is close to zero, the risk that negative shocks may trigger deflationary spirals increases. Moreover, the countries in the European Union do not have the same economic situation and some of them may have positive inflation, while others may find themselves in deflationary situations. 

Secondly, let’s take a look at how monetary policy is transmitted. We will consider six transmission channels and, as an example, we will consider a monetary expansion, specifically a reduction in the interest rate. The transmission mechanism is the process through which monetary policy decisions affect the economy, and particularly the target variables. In this article, we are considering the policy interest rate as the standard tool of the central banks. This is adopted in the money exchange operations between the ECB and the counterparties, mostly euro-zone banks.

The first link in the transmission mechanism is represented by the effects of changes in official rates on short-term interest rates in the money market (interest rates on operations between banking intermediaries). Generally, by adjusting liquidity in the system, the central bank aligns money market interest rates with the official rates. Thus, we are concerned with the interest rate channel, the typical example found in macroeconomics textbooks that explains how monetary policy works. In the euro-zone, there is a high share of loans and deposits in assets and liabilities, thus, as a consequence, interest rate pass-through is a key element of this interest rate channel.

The second tool analysed is the financial asset price channel. When the ECB reduces the interest rate, consumers tend to change their preferences from bond market to equity market. Naturally, the result will be an increase in stocks’ prices, triggering two more effects: wealth accumulation and Tobin’s “q” increasing. The first  allows consumers to increase their consumption, resulting in an increase in output and, consequently, an increase in inflation. The second, Tobin’s “q”, can be represented as a ratio between the market value of a firm acquired in financial markets and the value of the same firm if somebody were to purchase its capital stock on the goods market. If Tobin’s “q” is high, the market value of a firm is high relative to the replacement cost of capital, and new investments are relatively less expensive compared to the market value of the firm. Because of that, a firm can issue stocks at a higher price in relation to the cost of the investments it will make. Thus, companies increase their investments and, consequently, the output increases and so does inflation.

Proceeding, the bank lending channel is taken into analysis. It is important to remember that banks have customers’ deposits among their liabilities and loans among their assets. A monetary expansion feeds the bank deposits and, consequently, banks’ assets must increase through a loans’ expansion. This further enhances consumptions and investments, leading to an expansion of inflation rate. It is essential to specify that the dimension of the effect depends on the funded ratio of the banks. 

The balance sheet channel explains the phenomenon that sees a monetary expansion producing an increase in the value of stocks and debt securities, boosting the collateral value. This higher value of collateral reduces the risk premium and the interest rates on loans, producing an increase in investments, output and consequently on the inflation rate. This process is called “financial accelerator”. If output increased the past year, today’s net worth of a firm will increase further, with a beneficial effect on collaterals, interest payments, investments and, once again, output. Moreover, an expansive monetary policy increases firms’ net worth, causing a reduction in adverse selection and moral hazard. Low interest rates push banks towards more lucrative and consequently riskier investments. Furthermore, the balance sheet channel can also operate through the companies’ cash flow channel. A monetary expansion reduces the interest rate and, consequently, there follows a reduction in financial expenses for firms, with positive reflections on the cash flow. Firms increase their availability of internal financing and reduce the riskiness of investments for financiers, who demand lower interest rates on loans.

Finally, the last channel analysed is the risk-taking channel, which is strictly connected to the balance sheet channel. Indeed, monetary policy, increasing the value of collaterals, cash flow and assets, can influence the risk tolerance of financial intermediaries. With an expansive monetary policy, the risk tolerance increases producing an expansion of loans and, therefore, an increase in investments, consumptions, output and, finally, in inflation.

Understanding monetary policy is hard but crucial to comprehend how and why central banks respond to critical situations. After a decade of extremely low rates, inflation has started to rise again, and the European Central Bank has naturally responded with an increase in rates, which inevitably raised the interest rate on mortgages, resulting in negative consequences for individuals who had taken out variable-rate mortgages. These negative consequences brought about by a restrictive monetary policy, however, are a “necessary evil” to avoid a high inflationary situation that would diminish consumers’ purchasing power and erode their savings.

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