Central Banks and Limitations of Monetary Policy

The central bank of any nation worldwide is responsible for managing the country’s monetary policy. They also often have the responsibility of maintaining price stability and inflation.

Central banks need to have the significant qualities highlighted below to be more effective in their responsibilities.

Transparency

It is ideal for a central bank to be transparent in its decision-making. Central banks do this by producing inflation reports that give their views on the indicators they watch to arrive at their monthly interest rate decisions. When making these decisions, they typically address the below areas in the given sequence.

• Credit conditions and broad money overview.
• The state of financial markets.
• Changes in the real economy, such as employment dynamics and
• Evolution in prices.

Transparency helps central banks gain reputation and credibility, which, in turn, facilitates their ability to shape inflation expectations and more effectively achieve their inflation target.

Independence

Central banks need to be independent from their government’s influence. In most cases, independence from the government is only up to a certain extent as the government appoints most top officials of the central bank.

There are also degrees to this independence. Some central banks have both operational and target independence, meaning they decide interest rates, define and set the inflation rate, and choose the timeframe to meet the target. The ECB is a prime example. In contrast, others, like those in New Zealand, Sweden, and the UK, are bound by government-set inflation standards and targets, granting them only operational independence.

Credibility

A central bank is a national institution granted the prerogative to control the printing and supply of money and credit. Central banks play important roles in the economy since they are the sole suppliers of currency to the government, bankers to commercial banks, lenders of last resort, supervisors of payment systems, and implementers of monetary policy.

For a central bank’s measures to resonate and be effective, the public’s trust is paramount. In an era where inflation-targeting is crucial, the credibility of a central bank isn’t just about the policies they enact but about the public’s unwavering confidence in those policies. Especially during volatile times, a central bank’s credibility ensures stability and instils faith in the financial future.

Inflation and Exchange Rate Targeting

Inflation Rate Targeting

When an inflation target is set, it acts as a benchmark. Other policies are implemented to ensure that the inflation rate within the economy does not grow beyond/below ±1.0 percent of the targeted inflation rate within a given period of time.

Regardless of who sets the target, either the central bank or the government, the specific target level and the timeframe within which it should be achieved are vital elements in every inflation-targeting approach.

While inflation-targeting strategies might differ slightly across different economies, their effectiveness is widely believed to hinge on three qualities of a central bank: independence, credibility, and transparency.

The inflation target cannot be set at 0% because it might lead to deflation, which is negative inflation. It can also not be set at a high percentage (like 10%) because such higher values may lead to price instabilities and high inflation uncertainty.  Most central banks agree that 2% is the best inflation rate target as it is high enough to cushion against deflation and low enough not to destabilise prices.

Note: Inflation targets do not aim at the current inflation but usually inflation two years ahead for two main reasons:

1. The monthly headline inflation rate, targeted by central banks in many economies, represents the yearly increase in the cost of a basket of goods and services. Essentially, it reflects past price changes.
2. Changes in interest rates today will require time to fully impact the real economy due to the gradual process of the monetary transmission mechanism.

Exceptions in Inflation Targeting

The two central banks that do not adopt inflation-rate targeting are the Bank of Japan (BoJ) and the US Federal Reserve System.
Japan’s central bank, the BoJ, does not target an explicit measure of inflation because Japan has been battling deflation for nearly two decades. Despite measures taken, including printing money, inflation has remained weak. Inflation targeting is primarily seen as a method to combat and control inflation, making it seemingly irrelevant in an economy consistently facing deflation.

Interestingly, the US Federal Reserve does not set an explicit inflation target because a strict focus on inflation might clash with the Federal Reserve Act’s mandate: “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Some suggest that targeting inflation could jeopardize the objective of “maximum employment.” However, in practical terms, the Fed views core inflation around or slightly under 2% (as measured by the personal consumption expenditure or PCE deflator) as synonymous with “stable prices.” Consequently, financial markets closely monitor this US inflation metric to predict the Fed’s interest rate decisions.

Exchange Rate Targeting

Many developing economies choose to target their currency’s exchange rate as opposed to targeting a domestic inflation level. They do this by establishing a fixed or range-bound value for their currency relative to a major global currency and stabilize their currency by trading it in the forex market relative to the chosen major global currency. By linking its currency, a country can essentially “borrow” the inflation stability of the more developed economy.

Exchange rate targeting can only be successful if the monetary authority’s commitment to and ability to support the exchange rate target is credible. Some countries may choose to adopt the US dollar as their official currency, completely replacing their native currency, a situation called dollarization.

Contractionary and Expansionary Monetary Policies.

Recall that central banks control liquidity in the economy by adjusting their benchmark interest rates. As such, contractionary policies aim to reduce the money supply’s growth rate and potentially curb the economy’s growth. If the central bank, anticipates rising inflation due to increased economic activity, it might increase interest rates, and eventually “contracting” the economy.
On the other hand, when the economy slows down and both inflation and monetary trends appear weak, central banks can boost liquidity by reducing their target interest rate. This is known as an “expansionary” monetary policy.

Neutral Rate of Interest

The “neutral rate of interest” is the reference point for determining whether a central bank’s policy rate is high or low. It is an interest rate that will neither grow nor shrink an economy, and it should correspond to the average policy rate over a business cycle.

If the policy rate exceeds the neutral interest rate, it is considered high, and the monetary policy is seen as contractionary. If the policy rates is below the neutral rate, it is considered low, and the monetary policy is seen as expansionary.

The neutral rate of interest consists of:

• The real trend rate of growth of the underlying economy,
• Long-run expected inflation.

The real trend rate of growth is considered as the sustainable economic growth rate that results in stable inflation over time. If, for instance, an economy’s credible inflation target is 2% annually and its sustainable long-term growth is believed to be 1.5% annually, then the neutral rate can be calculated as:

$$ \text{Neutral rate} = 1.5\% \text{(Trend Growth)} + 2\% \text{(Inflation Target)} = 3.5\%. $$

Thus, a policy rate exceeding 3.5% would be considered contractionary, while one below this rate would be seen as expansionary.

Sources of Shocks to Inflation Rate

The shocks to inflation rates can be classified as either demand or supply shocks.

Demand shocks occur when the rise in interest rates is caused by increased consumer confidence, leading to increased consumption and investment growth, and can be controlled by tightening monetary policy to control inflation.

On the other hand, supply shock occurs when an inflation spike is due to external factors, like a significant jump in oil prices. In this situation, raising interest rates might worsen the situation as consumers are already dealing with increased costs that may have decreased their disposable income and forced them to reduce their spending, eventually leading to increased unemployment.

Therefore, it is advisable not to try to control inflation shocks caused by supply shocks. For this reason, monetary authorities need to accurately pinpoint the cause of inflationary changes before deciding to engineer an expansionary or contractionary monetary policy phase.

Limitations of Monetary Policy

1. Problems in the Monetary Transmission Mechanism

Monetary policy actions are conveyed to the economy through channels like bank lending rates, asset prices, and expectations. Sometimes, the intended effects might not permeate the economy as expected.

For instance, raising interest rates might not always result in the desired economic slowdown if long-term rates fall due to market expectations. Bond market vigilantes play a role in affecting yields based on their perception of monetary policy’s efficacy.

Extreme cases like a liquidity trap, where money injections no longer influence interest rates, can render monetary policy ineffective, especially during deflation.

2. Relative ineffectiveness of interest rate adjustment in a Deflationary Environment and Quantitative Easing as a Response

Deflation, a continuous fall in prices, is challenging for standard monetary policy. During deflation, slashing interest rates to near or below zero may not be effective, and may lead to a liquidity trap which can result in reduced consumer spending, further deflation, and a rise in the value of real debt, as witnessed in Japan post the 1990s property bubble collapse.

If standard monetary policy tools fail, alternatives like quantitative easing (QE) can be utilized. QE involves large-scale asset purchases to inject money into the economy. Though it aims to stimulate lending and boost economic activity, its success is not guaranteed.

Central banks can buy a variety of assets under a QE program if permitted by the government. However, buying risky assets can be dangerous. Acquiring bad assets that incur losses might lead to a severe confidence crisis in the central bank’s primary product: fiat money.

Monetary Policy in Developing Countries

Emerging economies often encounter notable challenges in the effective implementation of monetary policy, particularly in achieving price stability. These challenges encompass:

• a lack of a well-established government bond market and a mature interbank market, essential for carrying out monetary policy.
• a history of struggles with inflation control, which undermines the credibility of their monetary policy objectives.
• an unwillingness by governments to give true independence to their central banks.
• Rapid changes in financial methodologies frequently alter the meaning of money supply.
• a constantly evolving economy, complicating the determination of the neutral interest rate and the stable connection between the money supply and the real economy.

Question #1

While politicians and central banks may share certain economic goals, which objective will politicians least likely prioritize?

1. Promoting economic growth.
2. Boosting employment rates.
3. Addressing inflationary concerns.

Solution

The correct answer is C.

Addressing inflationary concerns is primarily the domain of central banks. Politicians, in contrast, often prioritize boosting employment rates and promoting economic growth.

Question #2

If a central bank raises its policy rate, how might this action alleviate inflationary pressures?

1. By dampening consumer demand.
2. By affecting the foreign exchange value of the domestic currency.
3. By elevating asset prices leading to increased household wealth.

Solution

The correct answer is A.

When policy rates rise, borrowing becomes costlier, leading to decreased consumer demand, which subsequently reduces inflationary pressures.

B is incorrect. A hike in the interest rate typically strengthens the domestic currency, making imports cheaper and potentially decreasing inflationary pressures.

C is incorrect. Higher policy rates often depress asset prices since banks have reduced lending to businesses and consumers, leading to decreased investment and consumption.

Question #3

Which of the following is least likely considered a limitation of monetary policy?

1. Encountering a liquidity trap.
2. Achieving price stability.
3. Responding to bond market vigilantes.

Solution

The correct answer is B.

Achieving price stability is one of the core objectives of monetary policy, not a limitation. Both A and C, liquidity trap and bond market vigilantes, respectively, pose challenges to the efficacy of monetary policy.