Monetary policy is a blunt tool

Classical economic theory describes the primary objectives of a central bank as maintaining price stability and controlling inflation.

In most Western economies, central banks defend their independence from political pressures. They insist that their actions are always motivated by the need to protect households and businesses from the corrosive effects of inflation. Still, politicians like the current US president often blame central bankers for putting spokes in the wheels of economic growth by not reducing interest rates.    

Monetary policy is a tool for controlling inflation. It does not do this perfectly, and certainly not quickly or painlessly. Put simply, it is a blunt tool that often gets the job done adequately. Monetary policy is less than perfect because many economic forces, some good and some harmful, can affect inflation.

Central bankers often adopt the golden rule of targeting a two per cent inflation rate that economists consider conducive to healthy economic growth. In reality, interest rate management does not always get inflation exactly right, but it effectively controls inflation over the medium term.

The economic boom at the end of the last century helped economies grow fast. Then came the dot-com bubble burst in the summer of 2020. In   March 2008, Bear Stearns was rescued, and in September 2008, Lehman Brothers failed. This sparked a global financial crisis.

The Federal Reserve and the European Central Bank, which had already lowered interest rates to low levels, had to use other monetary policy tools, such as large-scale asset purchases or quantitative easing, to save the real economies from massive shocks. This saved Western economies from a deep recession or even a depression. 

This snapshot of recent global economic developments holds a few lessons. The first lesson is that getting monetary policy right is not easy. With the benefit of hindsight, many economists today agree that after the 2001 9/11 terrorist attacks, central banks were too slow to withdraw stimulus. Conversely, after the global financial crisis that started in 2008, stimulus was withdrawn too fast.

The COVID-19 pandemic was undoubtedly the most significant economic shock of the last three decades. Entire sectors of the global economy shut down overnight, millions of jobs were lost, and fears of deflation – a generalised and sustained decline in prices – arose.

During this severe stress, central bankers adopted quick and decisive strategies to limit the damage. They cut interest rates to near zero. At the same time, governments adopted extraordinary fiscal stimulus to kick-start the recovery. 

During the pandemic, monetary policy responded first to the threat of deflation and then to rapidly rising inflation once the economy reopened. With the onset of the Ukraine war, many realised that interest rates alone could not address the inflation elements caused by supply chain disruptions. 

Monetary policy alone cannot address economic weaknesses

Of course, monetary policy alone cannot address economic weaknesses like rising inequality, housing shortages, house price inflation and structural flaws in economic models.

Central bankers, like Mario Monti and Christine Lagarde, have often appealed to political and business leaders not to expect too much from monetary policy and to undertake the necessary economic reforms with more urgency.

When he was governor of the Bank of England a decade ago, Canadian Prime Minister, Mark Carney, remarked: “Central banks are being simultaneously accused of being ineffective and too powerful.” The battle of wits between politicians and central bankers will not go away anytime soon.

Sometimes, the economy experiences what economists call “relative price shocks”. These are fluctuations in specific prices, often for energy and food, caused by geopolitical events, droughts and transportation disruptions. While such relative price increases do not usually last for long, monetary policy can do little to reverse them.

Housing affordability has become a significant problem in many Western countries. While low interest rates can help mortgage holders to cope, an increase in demand caused by fast population growth can make it difficult for first-time buyers to start climbing the property ladder. Monetary policy cannot address long-running structural problems on the demand side that affect home ownership affordability.

The EU and the Federal Reserve set interest rates for their blocs. Realistically, the one-size-fits-all method of setting rates is defective, as one US or EU member state may face very different economic challenges from any other state or EU country.

Central bankers are correct when they argue that low, stable inflation is fundamental for shared prosperity. Still, monetary policy cannot do everything a country’s economy needs. It remains a blunt tool that is useful but not consistently effective.