Central banks need medium-term policy to manage annual inflation

Central banks, in any nation, have the crucial task of tracking price stability. They do so by dispensing diverse forms of money, setting an assortment of interest rates, yielding fiscal revenues, outlining the unit of account, and importantly affecting marginal costs of production via credit regulations and other policies.

Scrutinizing price surges and the rising cost of living, questions are being asked on whether central banks have lost their ability to control inflation. Most of you might recall after soaring in the 1970s, inflation rates in most nations have declined significantly since the early 1980s and stabilized around 2% in the years before the global financial crisis.

This movement in my assessment corresponded with the acceleration of globalisation, triggering a debate on whether globalisation could be one of the main drivers of the disinflation process, and whether the ability of central banks to control inflation could be undermined as a result.

Admits this thinking, the 2008 financial crisis has in my assessment introduced new economic terms into popular use, like central bank undertaking quantitative easing or cash injection, forward guidance i.e., central banks saying what they think interest rates might be in the future, negative interest rate i.e., central banks charging commercial banks for depositing money with them and macro prudential policy i.e., central bank regulations aiming for financial stability, to mention a few.

These are in addition to using interest rates to target price stability of inflation and are unconventional or fairy new monetary policy tools. All of this raises the question: a key question remains, are central banks doing too much or lost their position or is what they are doing working to help the economy? Or should I resolve that the problem with quantitative easing work in practice, but doesn’t work in theory?

Much as I know quantitative easing has been renewed once again in certain nations, one interesting challenge remains injecting cash to boost the economy because interest rates have been cut or even minimised is one of the most controversial monetary policies in recent times.

Cutting rates is one way of making lending cheaper, which can increase borrowing by households and firms who then respectively spend and invest and so aid the economic recovery.

But when interest rates aren’t working, the central bank needed another way to increase the amount of credit in the economy. Quantitative easing was that policy.

Simply put, central banks electronically issued money and used it to buy bonds, which are government or corporate debt. This put money onto the balance sheets of businesses that thus sold their bonds in exchange for cash, which central banks expected would be invested and boost the recovery.

From an economic point of view, this kind of measurement undertaken by some central banks, in my view, represents a new era in monetary policy and all these measures remind me of a leading scholar in monetary economics Milton Friedman.

Researching the causes of the great depression that followed the last systematic banking crash in 1929, concluded that the crisis was due to poor monetary policy fundamentally changing our understanding of that period and post-crisis policies.

To this date, Friedman in my view remains a divisive figure in popular opinion, but that is largely a reflection of the very libertarian and pro-free-market position, and this somehow could have influenced President Regan’s (US) and Thatcher’s (UK) ideology driven towards smaller government and more laisser-faire capitalism.

Although is subject to debate, Friedman’s theories on monetary policy and other economic concepts, such as what drives people to consume, remain deeply engrained in the subject and public policy today.

It is fair to say that Friedman to a certain extent views on the great depression was game-changing in understanding monetary policy issues and what needs to be done. The reasons in my view are clear. In the aftermath of the 2008 financial crisis, policymakers were at greater pains to try to avoid the mistakes made in the 1930s, most of which had been acknowledged by Friedman.

Because of such insight, since the crisis research on how central banks are grappling with monetary policy signals that central banks around the world have thrown the kitchen sink at reviving their battered economies, keen to avoid accusations of repeating the mistakes pointed out by Friedman.

In all these, I am of the view that the recent acceleration in globalisation has mainly taken three forms that could affect inflation dynamics and monetary policy that nations must grapple with: trade integration, labour market integration and financial integration. Sincerity in terms of trade has led to a greater sensitivity of domestic price levels to external price shocks.

This means that variations in global prices can indeed have major temporary effects on nations’ domestic prices and in this case energy prices are one of the major determinants of the short-term fluctuations of most nations’ headline inflation. More importantly, trade with low-cost countries has increased massively in the last two decades, which has logically resulted in a reduction in the price of imported goods.

Likewise, global competition between firms might in my opinion have also reduced the pricing power of domestic businesses, while the integration of billions of workers into the global labour market some working from distances aka working from home has likely reduced the bargaining power of domestic workers. Largely, the literature shows that the contribution of globalisation to the global disinflation movement since the 1990s remains a challenge to central banks in managing and fulfilling their role.

Had he been alive, Friedman, born in 1912 in Brooklyn, the economics Nobel Prize winner would undoubtedly have had a lot to say about the event that followed a few years later, the reaction of policymakers to them, and where the world find itself today, especially on the role of central banks in managing the economies.

To pen down my thinking on whether central banks are doing too much or what they should do to be more useful, a more important question in my assessment is whether globalisation-driven trends affect the transmission mechanisms of monetary policy and reduce the ability of central banks to fulfil their mandate.

Why? because the transmission channels of monetary policy could be affected at various levels. One, central banks could lose their ability to device inflation if inflation becomes a function of global slack instead of being a function of domestic slack. Two, central banks could lose control of short-term rates if rates become a function of global liquidity instead of the liquidity provided by the domestic central bank.

Three, central banks could lose their hold over domestic inflation and economic pursuit promoted by both public and private firms if long-term interest rates depend only on the balance between savings and investment at the global level, and not at the domestic level.

Certain the theoretically greater effects of external price shocks on more open economies and the potential alteration of monetary policy transmission channels in more integrated financial markets, in my view, globalisation will force central banks to take external developments into account in their monetary policy decisions.

Thus, central banks need to have a medium-term policy goal orientation instead of trying to manage yearly inflation rates that are driven by global shocks.

Largely, I think if central banks adopt flexible exchange rates, central banks will be able to maintain their ability to stabilise inflation at the targeted level in the medium term, even though globalisation does not facilitate their duty.

One thing to remember “A Level Economics” has no room for what is unfolding in the world financial market. Smart thinking and novelty are necessary to swing with global financial dynamics waves.