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Central bankers were in reflective mood at last week’s annual Jackson Hole confab. At the 2022 meeting, when inflation was close to 40-year highs, the message from monetary policymakers was simple: interest rates must go higher. This year, while inflation remains “too high”, in the words of US Federal Reserve chair Jay Powell, higher rates have at least begun to pinch demand and price growth is easing. The discussions instead shifted towards the evolving global economic landscape, from the climate transition to geopolitical tensions. The message: central banking is only going to become more complex.
When monetary policymakers set interest rates to hit their inflation targets, they must assess where they think demand is relative to supply. Put simply, if demand is estimated to be higher than supply, elevated interest rates help to cool an overheating economy — and vice versa. Economic upheaval, however, makes this calibration significantly harder.
The past three years have brought substantive change to the global economy. The pandemic has left long-lasting scars, including higher levels of worker inactivity in Britain, for example. Geopolitical ructions have led to the rewiring of supply chains, and the climate transition is driving big shifts in global energy markets too. Meanwhile ageing demographics, the AI revolution and rising demands on government spending adds more moving parts, with implications for both supply and demand. Powell described rate-setting today as “navigating by the stars under cloudy skies”.
The added problem for central bankers is that interest rates, which impact demand with long and variable lags, are a blunt tool to wield in a time of rapid change. “There is no pre-existing playbook for the situation we are facing today — and so our task is to draw up a new one,” said ECB president Christine Lagarde in her speech. Central banks will indeed need to adapt, otherwise their credibility as inflation-fighters will suffer. There are some lessons they should heed when doing so.
First, knowing when, and when not, to place weight on economic models is crucial. Since these are based on historical relationships, they become unreliable in the face of unprecedented events such as Covid, the war in Ukraine and Brexit. Lagarde acknowledged this when she quoted the Danish philosopher Søren Kierkegaard, who said that “life can only be understood backwards; but it must be lived forwards”.
Second, central bankers need to augment their understanding of supply dynamics. Assessing the demand side — from consumer confidence to credit conditions — tends to be easier than judging long-term shifts to trade, energy and the workforce. For decades, globalisation has supported flexibility in supply, with free-flowing goods, workers and capital. But new frictions threaten to make supply less elastic and more volatile. Monetary policymakers will need to draw on wider expertise and data sets to grapple with these dynamics.
A firmer understanding of structural economic changes at home and abroad will not only assist central bankers in setting rates today; it will also help answer the broader question of whether the 2 per cent inflation target they are aiming for remains relevant in the long-run. Even then, trying to control inflation with interest rates remains a complicated endeavour, particularly in a time of economic “shift and breaks”, to quote Lagarde.
The biggest takeaway from this year’s Jackson Hole ought to be that monetary policy, in its current form, is limited in what it can be expected to achieve. Deeper rumination on how monetary tools operate will be needed. And without structural reforms to support supply, volatile prices risk becoming the norm. That means governments need to step up, too.
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