Central Banks Mission Creep

by thorvaldur gylfason

THOR GYLFASON is professor emeritus of economics at the University of Iceland and research associate at the University of Munichs Center for Economic Studies. He also happens to be an accomplished music composer. Sample his work on Youtube.

Published April 24, 2024


There was a time not that long ago when monetary policy was easy, at least in concept. Central banks were supposed to regulate the amount of money in circulation to ensure that it helped facilitate economic stability. Grow the money supply too fast, and inflation would follow. Grow the supply too slowly and the economy would falter like an inadequately lubricated engine.

Business cycles were generally thought to originate on the demand side of the economy. If aggregate demand exceeded the supply of goods and services, the price level increased. Central banks responded by slowing the growth of the money supply. If aggregate demand came up short, unemployment rose, and central banks intervened with more money. 

Inflation and unemployment were inversely related. This inverse relationship was embodied in the Phillips Curve, which served as a menu of sorts from which governments could choose between keeping inflation low by tolerating some unemployment and keeping unemployment low by tolerating a little inflation. This dance of monetary policy wasn’t always easy to get right in practice. But from 1945 to 1973, the basic steps were pretty straightforward.

Did Macroeconomics Die in 1973?

Then, disaster struck. The OPEC cartel sharply increased the price of oil by collectively limiting supply — first in 1973-74 and then again in 1979-81. Global business responded by reducing production or by passing on the extra costs to customers. Suddenly inflation and unemployment rose hand in hand. Was the Phillips Curve dead?

Nope. The problem was simply that the price shock imposed by OPEC on oil importers required a supply-side contraction to restore equilibrium. This was really nothing new in terms of accepted economic theory — price shocks of this magnitude just weren’t that common. But this doesn’t mean central banks were prepared to switch tactics at the drop of a commodity crunch. The Phillips Curve just wasn’t there to offer a roadmap. Indeed, decision-makers were caught between a rock and a hard place.

Under the determined leadership of Paul Volcker, the U.S. Federal Reserve knocked inflation down from 14 percent in 1980 to 2 percent in 1986 — though at the price of accepting an increase in unemployment from 6 percent in 1979 to 10 percent in 1982.

Mercifully, the global economy’s excursion into supply-side hell was relatively short. But the trauma did drive home the sense that macroeconomic policy required an understanding of the impact of shocks to supply as well as to demand. 

The lesson was reflected in the establishment of the European Economic Area in 1994, creating a free trade zone in much of Western Europe, along with the adoption of a common currency in 1999. The main aim of both projects was to facilitate cross-border trade, increasing productivity by enlarging markets, increasing competition and facilitating more specialization. This proved to be one of the most successful supply-side stimulus packages of all time.

Breaking Free

One conclusion is inescapable: because increased trade stimulates the supply of goods and services and drives down prices to competitive levels, it behooves central banks to promote trade to keep inflation low without generating unemployment. But most of the world’s central bankers remain stuck in their old ways, arguing they would be exceeding their mandates if they explicitly defended open trade.  Likewise, the central banks of those European countries that have not yet adopted the euro ought to advocate currency integration as a barrier to inflation.

It is telling that Sweden’s Riksbank Governor Stefan Ingves only pushed for the euro after he’d stepped down from 16 years on the job. Like most other central bankers, he did not try to break free, even though the Riksbank is formally independent of the elected government. And in this, Sweden is not alone.

The near-exclusive resort to raising interest rates to counter inflation, regardless of its source, is at least partially explained by the streetlight effect, where policymakers are inclined to apply the easiest, most familiar remedy rather than the right remedy.

The crux of the matter is this: central banks should be allowed — encouraged — to advocate and apply countermeasures against the roots of inflation, whether on the demand side of the economy or the supply side. An increase in interest rates is an unsatisfactory response to accelerating inflation when the source of the inflation is, say, housing shortages, OPEC maneuvers or supply-chain bottlenecks.

The near-exclusive resort to raising interest rates to counter inflation, regardless of its source, is at least partially explained by the streetlight effect, where policymakers are inclined to apply the easiest, most familiar remedy rather than the right remedy.

Interest Rates and Inflation Targets

In the 1990s, many central banks changed their ways in one important fashion, relying more on interest rates than the money supply. This change reflected the recognition that the money supply had always been an “endogenous” variable that the government cannot fully control. This is due, among other things, to the fact that foreign exchange reserves are part of the money supply, and reserves vary along with market-driven international trade and direct investment.

Consider, too, that commercial banks also affect the money supply since they, too, have the discretion to create or destroy liquidity. This became quite clear in Iceland’s financial crash of 2008, when the machinations of a rogue private banking sector dragged the economy into deep recession.

Many economists and bankers around the world welcomed interest-rate-based inflation targeting as a new policy framework despite a flaw that very few observers acknowledged. As a small, open economy, Iceland bore witness, having adopted inflation targeting in 2001. Interest rates were kept high to curb domestic demand. But this led to an inflow of foreign currency — much of it so-called “carry trade” in which speculators borrow cheaply in one currency, invest in another currency paying higher interest and pray that exchange rates don’t turn against them. And since foreign exchange reserves are part of the money supply in the books of the banking system, an increase in interest rates could directly fuel the inflationary fire through capital inflows. That is why the IMF advocated the imposition of capital controls in Iceland after the 2008 financial meltdown, along with more market-oriented measures.

Inflation as a Power Contest

The reluctance of governments to address the systemic error described here seems to have stood in the way of new thinking about monetary policy. Many central bankers still adhere to the old view, which was understandable when incomes were more equally distributed among workers and their employers. This was the view that unreasonable wage demands by trade unions were a prime source of cost inflation, a view not particular to Europe — think Detroit before the 1980s.

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In some ways, the consensus that the job of central banks was solely to control the money supply had the positive impact of rationalizing the independence of central banks. But there is no longer any clean division of labor between central banks and the rest of government because economic policy must increasingly reconcile policies designed to modulate aggregate demand with other policies that affect productivity, income distribution and relationships with the global economy. We ignore this reality at our peril.

main topic: Monetary Policy