Wednesday , April 14 2021

Because trust in the central bank is important

smallConsiders that it has been widely rumored for decades that confidence in central banks’ promise of stability is the key to fighting inflation. This view has spread after the failure of an inflation forecasting effort using simple measures such as money supply or national debt.

Gerald Braunberger

Experience has shown that in several episodes in economic history, a strong expansion of the money supply was followed by inflation. However, in several other episodes, inflation did not follow the increase in the money supply at all.

The relationship between money supply and inflation, once thought to be mountaineers like Milton Friedman, proved unreliable. Therefore, the attempt to control inflation mainly through the money supply has long been abandoned by monetary policy.

Playing with fear

The relationship between national debt and inflation is also unclear. Many examples can be cited, for example from Latin America, where high national debt has led to inflation. But there are counterexamples such as 19th-century Britain, which had a high national debt for many decades. This did not hurt the situation of sterling as the top currency in the world.

In the end, the decisive factor is whether the people involved in economic life, whether acting for companies or as members of private households, believe in the future stability of monetary value. If they expect a significant loss of purchasing power associated with inflation in the future, they may feel compelled to prefer spending to consumption or investment.

The sudden increase in macroeconomic demand caused by these benefits, if faced with a less flexible macroeconomic supply of goods, could trigger the fear that people feared. That is why central banks have made it very important for decades not to be afraid of rising inflation.

What is the purpose of inflation?

This is the purpose of the inflation targets that many central banks communicate to the public. About 60 central banks around the world have set these targets, for the most part the target rate is about 2 percent per year. Central banks regularly look at inflation expectations of people surveyed by consumers, entrepreneurs and financial market participants. If expectations remain stable near the official inflation target, inflation expectations are said to be stable.

Such a monetary policy seeks to influence the economy by changing the short-term key interest rate in such a way as to achieve the desired inflation. There is no active control of money supply. Instead, the money supply is considered to be adapted to the needs of the economy through the demand for money and credit of the participants in the economic process.

This idea, which has kept inflation very low in many countries in recent decades, has undoubtedly been very successful. However, it has faced a number of challenges in recent years. Initially, inflation rates in many countries remained below targets, which do not need to cause immediate problems, but have cast doubt on the ability of central banks to raise inflation rates if desired.

The financial crises of 2008 and 2009 showed how much central banks can absorb the need to stabilize their fast-growing, dynamic and crisis-prone financial systems, especially in an environment of structurally slow economic growth and little confidence in the effectiveness of fiscal expansion. . Through emergency instruments such as extensive securities markets, central banks facilitated the financing of governments and companies, which resulted in a significant increase in the share of debt in world economic output.

The pandemic once again made clear the need for expansionary monetary policy in severe crises, but also raised the question of how much central banks have the leeway against highly indebted national budgets and fragile financial markets if they had to respond to the threat. inflation tightening their policies. The continued stabilization of inflation expectations may prove to be a monetary policy challenge.

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