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. They do this by producing reports and airing their views on economic indicators used to develop the monetary policy.

For instance, central banks produce inflation reports that provide insights into the various indicators they monitor when determining their monthly interest rate adjustments. When making their assessments, they typically address these topics in the given sequence:

• Overview of broad money trends and credit conditions.
• The state of financial markets.
• Changes in the real economy, such as employment dynamics and
• Trends in pricing.

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

While governments can set inflation targets and instruct central banks on interest rates, there’s a risk. Politicians aiming for reelection might keep interest rates artificially low, potentially leading to inflation surges. Hence, the prevailing sentiment is that monetary decisions should be made by an entity distant from political agendas, positioning central banks as exclusive currency providers.

Yet, there are degrees of independence. Government officials often select central bank leaders. For instance, the US president appoints the US Federal Reserve Board’s chair. As such, achieving total detachment from political sway might be idealistic but challenging.

Different central banks have varying degrees of independence. Some 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 autonomy.

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 instills faith in the financial future.

Inflation and Exchange Rate Targeting

Inflation Rate Targeting

The inception of this now widely accepted inflation-targeting approach can be traced back to New Zealand. In 1988, Roger Douglas, the New Zealand Finance Minister of the time, put forth a transformative economic policy. The country aimed to curtail inflation, which stood at approximately 6%, bringing it within a more controlled range of 0 to 2%.

This inflationary target could be a benchmark. When this is the case, other policies are implemented to ensure that the inflation rate within the economy does not grow beyond 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. For instance, in the UK, the Bank of England’s target is CPI inflation within \(\pm\)1.0 percentage point of 2%.

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. Moreover, inflation targeters 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.

While the specifics of inflation-targeting mandates differ across nations, they generally include a clear inflation target within set boundaries and require transparency from the central bank in its goals and actions. Typically, these guidelines are established in laws that set formal duties for the central bank.

Exceptions in Inflation Targeting

The two central banks that do not adopt inflation-rate targeting are the Bank of Japan 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 emerging economies prioritize targeting their currency’s exchange rate rather than focusing on domestic inflation. They establish a fixed or range-bound value for their currency relative to a major global currency and stabilize it by trading in the forex market. By linking its currency to a stable, low-inflation economy, a country can essentially “borrow” the inflation stability of the more established economy.

Consider a scenario where a developing nation wishes to peg its currency to the US dollar. Assuming similar inflation rates and consistent relative price levels, the currency should remain near its targeted value if there are no unforeseen economic disruptions, effectively inheriting the foreign nation’s inflation scenario.

However, if the developing country’s economy accelerates and its inflation surpasses that of the US, its currency might devalue against the dollar. To maintain the targeted exchange rate, the country’s central bank would buy its currency and sell foreign reserves, leading to decreased money supply and raised interest rates.

Conversely, if its inflation rate drops compared to the US, the central bank would do the opposite, increasing the money supply and dropping interest rates.

In real-world scenarios, a developing country’s central bank intervenes regularly to maintain the stability of its currency value. However, an essential takeaway from this example is that when a monetary authority aims for a specific exchange rate, the domestic economic conditions, including interest rates and the money supply, must adjust to support this goal. As a result, these domestic economic indicators might experience greater fluctuations and volatility.

Despite potential pitfalls, several currencies are still pegged, especially to the US dollar. Such currencies with pegged currencies include Saudi Arabia, Bahamas, and Lebanon.

Some currencies have a “managed exchange rate policy,” fluctuating within a set range managed by the monetary authority.

In some cases, countries even adopt the US dollar as their official currency, completely replacing their native currency, a situation called dollarization. Such countries include Panama, Ecuador, and East Timor.

Contradictory and Expansionary Monetary Policies.

Recall that central banks control liquidity in the economy by adjusting their benchmark interest rates. As such, contractionary aims to reduce the money supply’s growth rate and potentially curb the economy’s growth. As such, if they anticipate rising inflation due to increased economic activity, they might increase interest rates, reducing available funds in the market.
On the other hand, when the economy slows 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 terms “high” and “low” for policy rates are relative. Their point of reference is often the “neutral rate of interest,” a rate that neither stimulates nor restrains economic growth. If the policy rates exceed the neutral rate, the monetary policy is seen as contractionary. If they are below the neutral rate, it’s viewed as expansionary. Ideally, over an economic cycle, the neutral rate should be equal to the average policy rate.

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 shock to inflation rates can be classified as demand and supply shocks.

Demand shock occurs when inflation is rising beyond its target or simply in a way that threatens price stability due to an increase in the confidence of consumers and business leaders, which in turn has led to increases in consumption and investment growth rates. In this case, it might be appropriate to tighten monetary policy to bring the inflationary pressures generated by these domestic demand pressures under control.

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, already-burdened consumers dealing with high fuel costs might reduce spending, potentially causing a decrease in profits and a rise in unemployment.

Therefore, it is crucial for the monetary authority to accurately pinpoint the cause of inflationary changes before deciding to either tighten or loosen monetary policy.

Limitations of Monetary Policy

Monetary policy is used in the stabilization of prices and inflation control. However, monetary policy has quite a number of shortcomings and, as such, usually does not reach expectations. These shortcomings are discussed below.

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.

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 near or below zero might not be effective, leading to a liquidity trap. This can result in reduced consumer spending, further deflation, and rising real debt, as witnessed in Japan post the 1990s property bubble collapse.

If standard 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 is politicians least likely to 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.