Fighting inflation – The objective and effectiveness of monetary policy

The task of central banks to achieve their price stability objective, usually in terms of an inflation rate of two per cent, is by no means simple or easy. The reason is that inflation can be driven by either supply or demand factors, or a combination of both. However, the tools at the disposal of central banks to fight inflation, most notably interest rate setting, are best effective to address inflation fuelled by demand factors.

Addressing inflation driven by supply shocks, such as for example the rise in energy prices caused by the unprovoked invasion of Russia in Ukraine, can be more painful. This because rather than addressing excess aggregate demand, monetary policy would need to address the supply shortage by reducing aggregate demand to a lower level than that prevailing before the supply shock.

Conventional monetary policy is effective to influence demand primarily through a very specific channel, namely bank lending. By raising interest rates, a central bank signals that the cost of borrowing and the remuneration on saving is higher, which in turn should lead to a lower demand for loans to households, businesses, and government. Lower demand for borrowing by raising its cost cools down economic activity which in turn generates downward pressure on prices. Therefore, the pass-through of monetary policy to the retail level is critical for it to be effective.

The transmission of higher interest rates by local domestic banks hinges on the willingness of citizens in accepting the remuneration paid by domestic banks on their deposits. If depositors are willing to keep a very sizeable proportion of their financial savings in very short-term deposits, that usually earn very little or no interest, then banks could remain in a position to delay the transmission of higher interest rates on borrowers. However, there are incipient signs that domestic banks are starting to raise interest rates, particularly on term deposits, to lure new customers to enable such banks expand their business.

Competition for customer deposits is welcome and healthy for the domestic banking sector, not only because monopolistic practices are detrimental to consumers, but from a central bank perspective it enhances its ability to fight inflation.

Unfortunately, the business of banking in the EU remains very much local because in practice there are still obstacles for a vast number of citizens of one Member State to open a bank account in another, especially with heightened AML and CFT requirements by banks. Similarly, in the EU, both households and businesses, especially SMEs, in practice can only borrow funds from their home country to purchase their residence or to invest in their business. Therefore, it is essential that at the national level, competition is alive in the banking sector to ensure that monetary policy is indeed effective.

As in other countries, the transmission of higher central bank interest rates on government borrowing costs in Malta has been very rapid, with market participants, including domestic banks, being quick in demanding a higher yield on government paper. By contrast, to date, domestic banks have been somewhat slow in transmitting higher interest rates onto their customers, in respect of both deposit and lending rates.

This was also the case at the time of interest rate cuts when the Eurosystem was easing its monetary policy stance. In such period, domestic banks lowered interest rates to their customers at a slower pace. Indeed, bank lending rates in Malta were still higher than in the euro area when the ECB started raising interest rates in 2022, while deposit rates in some Member States were even negative, unlike in Malta.

This does not in any way mean that Malta is different from other economies or that a tighter monetary policy with effective transmission onto bank customers is unnecessary for Malta. As in the rest of Europe, inflation is also still too high in Malta, even though it is easing.

Moreover, while it is true that inflation has been partly driven by the effects of war and lingering supply bottlenecks created by the pandemic, there are signs that high inflation has not been solely driven by supply factors, and therefore a tighter monetary stance is warranted locally.

In the final part, I will highlight some of the sources of current inflation and why tighter monetary policy matters.

*The opinions expressed in this article do not necessarily reflect those of the Central Bank of Malta.