2022 has been a year full of economic uncertainty and inflation. During times of crisis like these, there is often quite a burden on central banks worldwide. The main goal of these banks is simple; keep the domestic currency stable, unemployment levels low, and prevent high rates of inflation. 

There are many factors as to why the world is facing very high rates of inflation right now. The worker shortages due to COVID-19 and the very high energy and food prices resulting from the invasion of Ukraine caused problems on the supply side. The very high money supply resulting from governments funneling a lot of money to households also did not help improve these supply issues.

Inflation is the public enemy number one. It is an evil threat that consumes our purchasing power. But who will save us from inflation?

To combat inflation, central banks take measures by using monetary policy. Quantitative tightening (QT) is the type of policy where a central bank reduces its balance sheet by selling its bonds, treasury bills, mortgage-backed securities, and other types of investments, reducing the money supply and increasing the interest rate, making it more attractive to save as opposed to spending.

Central banks announce the new interest rate every month. They either decrease it, increase it, or keep it. Although what you may have found out is that this rate does not match the one you see in your savings account.

Understanding why commercial banks do not match the central banks’ interest rates

During the pandemic, we faced a lot of uncertainty, job cuts, and less consumer spending. All of these, of course, led to higher amounts of savings by people. Commercial banks have ever since started facing very high rates of deposits.

Savings rates show a bank’s desire for deposits. From a bank’s perspective, would it be smart to increase the rates if the deposits were at an all-time high?

Interest rates, after all, are a rate of return that we receive on our savings account. Having already huge amounts of deposits, banks do not want to have even more by increasing the interest rates. This is the reason why our savings account’s interest rate doesn’t change while we watch the European Central Bank increase the overnight rate every month.

Talks of a Recession 

Although we have to eliminate inflation, we may face other problems during the process. Economies constantly go through a cycle. You may already know a little about the Business Cycle. After periods of economic peak and boom, we often see a rapid economic downturn and lower activity in the markets. One big reason behind this is the monetary policy that was used to combat inflation. As interest rates keep going up, people are pushed more towards saving.

Central banks are, of course, aware of this big risk. The federal reserve was said to decrease its balance sheet by 4 trillion dollars starting in May and throughout the summer of 2022. The decrease started gaining pace towards the end of the year because FED chair Jerome Powell realized that if they were to remove that much money from the market that quickly, they could trigger a recession.

It is also not very easy to do this rapidly. Mortgage-backed securities make up a large amount of the FED’s holdings, and these securities are not the most liquid of investments. This is another reason why the SOMA holdings we discussed earlier took its time to go lower.

Unorthodox Decisions

We know that inflation right now is a global phenomenon. But are there any exceptional central banks that decided to take different measures?

The Central Bank of Turkey is a good example. The Turkish central bank is likely the most famous one with its unorthodox and experimental policies that do not comply at all with economic theory. 

The central bank, heavily influenced by long-time president Recep Tayyip Erdogan, chose to decrease the interest rates amid year-over-year inflation of more than 80%, which caused more problems. According to Erdogan’s approach, achieving economic growth is the way to combat inflation. Cutting down rates and pushing people more and more to spend and invest. This is why the BIST100 index had a successful year in 2022. Because of the low-interest rates, the best option for investors was to invest in the stock market. Although the stock market’s growth was only little supported by foreign direct investment. Lower interest rates, of course, decreased the attraction of the Turkish Lira and caused the exchange rate to skyrocket, making it less and less valuable every month. Due to high inflation and a weakening local currency, foreign investors have already lost interest in Turkish securities. With elections around the corner, Erdogan continues using these policies to keep the pockets of low-income households full of borrowed money at the expense of future generations, causing a huge time mismatch.

The central bank’s actions in Turkey perfectly show why a central bank should be independent of the government.

We have seen similar issues with the Bank of England (BoE). 

With Liz Truss coming to power as the new prime minister, black clouds started approaching the BoE. The central bank took its measures against inflation much after the rest of the world, which put the British Pound in great danger, devaluating the currency and causing havoc in the financial market.

In the past year, we have also seen many emerging market economies panic and blunder with their monetary policy mainly due to the hawkish position of the FED. Although FED’s main goal is to combat economic troubles in the US, its policies are one of the strongest determinants of other currencies, rising prices, and risk of debt defaults in many emerging markets. Decisions by the FED are also particularly important for investors in the US stock market, which is not limited only to US citizens but millions of people around the world. For these reasons, we can easily say that the effects of FED policies are worldwide. 

The US although has other problems right now because the government has recently reached its debt ceiling. This means that the US Treasury can not go into debt any further to finance its financial obligations. In order to prevent issues like the government defaulting on its debt, the treasury has been taking measures, releasing more liquidity into the market, which does not overlap with the central banks’ QT actions. For things to go back to normal, the debt ceiling has to be raised. Although this is easier said than done because congress is in charge of the debt ceiling. Just like what happened in 2011 with Obama, it will come down to a “debt showdown” between republicans and democrats.

Central banks have the power to decide on the faith of the economy. This is easy… unless you have to deal with politics.