Is monetary policy the best way to fight inflation?

Luke Azzopardi is a Junior Economist at PKF Malta

Europe is suffering from red-hot inflation. Recent economic developments have generated inflationary pressures from both the supply and demand sides of the market, causing abnormal growth in general price levels.  The first increase in inflation became noticeable in early 2022 as a result of a conglomerate of COVID-19 pandemic-related issues, namely fiscal and monetary measure responses in peak pandemic times, price gouging, global supply chain disruptions, energy, and supply shortages (especially of chips), as well as increased production costs while demand went up.

Such economic environment significantly raised costs and companies passed those higher costs to the consumers who were able to acquire savings during the pandemic and were ready to spend it during this “summer of revenge spending”.   

As of 2022, the Russian invasion of Ukraine can be seen as another factor causing higher inflation as oil and commodities prices jumped in anticipation of and in response to the invasion.  In June, annual inflation reached 9.6% in the European Union while within the euro currency area inflation went up to 8.6%.

As a response to inflation, the ECB is now tightening monetary policy in Europe since it needs to ensure a level of price stability to not let inflation go fully uncontrolled.  The primary goal is to prevent a full-fledged recession or at least to dampen it.

The interest rate on the main refinancing operations was just raised by 75 basis points on 14th September to 1.25%, which is the first time since November 2011 that the rate was set at this number.  Even further interest rate hikes are expected by the ECB itself, which can also somewhat be foreshadowed by the pattern of past key interest rate changes.

There are many ways and ideas to fight inflation from ending COVID relief and subsidy measures to promoting work, savings and investment. The two most prominent ways to keep inflation low and fight it are monetary and fiscal policy.

Monetary policy involves influencing the demand and supply of money, primarily through the use of interest rates, which is usually carried out by an independent Central Bank like the ECB.  Higher interest rates increase the cost of borrowing and tend to slow down economic activity.  Monetary policy makers can engage in open market operations, in order to remedy for inflation.  This strategy involves central bankers actively trading in financial markets, influencing liquidity levels, and ultimately changing the long-term interest rates.

In fact, the Bank of England has decided to sell some stock of their bond portfolio over the next 12 months, with the aim of decreasing the money supply in circulation, and thus slowing down the economy.   Meanwhile, apart from hiking interest rates, the ECB has agreed to stop net asset purchases, as part of its policy tightening stance.  It then follows that by restricting spending and incentivizing savings, monetary policy can act as a brake on inflation.

In other words, monetary policy influences how much we have to pay to borrow and how much interest we receive on our savings.  It is safe to say that when looking at the distribution of the weight, higher interest rates hit homeowners the most but benefit savers who will gain a higher income.

Fiscal policy works through tax increases and government spending cuts to reduce the budget deficit. There is a lot of political pressure against fiscal policy, and it is highly political unpopular since raising taxes influences trust and eventually security for companies and through income tax also employees. The distribution ultimately depends on which taxes are raised.  Fiscal policy is mainly advised in very deep recessions.

In fact, in the 1980s, Ronald Reagan intended to improve the aggregate supply of the U.S. economy by reducing taxation, while slowing down fiscal spending and money supply growth in order to tame demand-side inflation. The Reagan camp believed that the solution for fighting inflationary pressures was to limit the government’s role in the free market.  On the other hand, Keynesian economics suggests that the solution to high inflation is to reduce the economy’s aggregate demand.  Keynes’ model emphasized the importance of using contractionary fiscal policy, such as tax increases, during inflationary periods.

In contrast with previous economic recessions but in line with Keynesian theory, the 2008 recession involved huge fiscal deficits which aimed to stimulate private sector demand and preserve employment.  As a result, the policy stance during the 2008 global financial recession required central bankers to resort to both conventional and unconventional monetary policy, involving adjustments of interest rates and quantitative easing.

The global financial crisis was not a usual economic downturn since it had originated from the easy availability of cheap credit.  This fuelled speculation in the asset markets, creating a bubble, mainly due to the low interest rate monetary policies.

Looking at the situation in the U.K., which has a large budget deficit and is possibly facing a long recession, fiscal policy may be advisable.  Since August, there have been huge changes in the financial markets, including a significant decline in the value of the pound.  As a result, the Bank of England’s Monetary Policy Committee (MPC) has agreed to raise interest rates by 0.5 percentage points.  Similar to the proposals implemented in the 1980s, newly elected U.K. Prime Minister Liz Truss has advocated for tax cuts to boost economic growth.

Moreover, even though Truss was initally against the idea of government intervention in the open market, she has recently announced an Energy Price Guarantee as a fiscal support measure in order to remedy for the price inflation caused by the volatility in wholesale gas prices.

In summary, monetary policy is generally relied on by governments to keep inflation low and seems to be working just fine for now.  Moreover, during recessionary periods, which the European and global economy is possibly heading towards, fiscal policy may also be taken into consideration in combination with monetary policy to help economic recovery.

However, the latest economic developments pose fresh challenges for monetary policy.  Given the underlying uncertainty, the foreseeable objective of monetary policy remains to push inflationary expectations down to 2%.  To achieve the necessary economic change and address concerns about competitiveness and long-term sustainability, fiscal and monetary policies will need to be implemented at both the European and national levels.  Therefore, central bankers should maintain a flexible approach in their policy setting.

In a nutshell, navigating this period of inflation and possible recession and finding the best way out, is a true balancing act for all policymakers and a serious stress test for us all.