The dilemma of central banks

Central banks around the world are being pressured by their governments to ignore inflation and focus on growth and jobs. But can monetary policy help in the latter goals?

Reserve Bank of India (RBI) governor Shaktikanta Das is under pressure to remain focused on growth even if inflation goes temporarily out of control. The RBI has so far managed to maintain a tightrope walk. Consumer price inflation spiked to 6.93% in  July, on the top of the 6.23% for June. That crosses the RBI’s inflation target of 4% with a tolerance of 2% on either side. Going strictly by its inflation-targeting mandate, RBI should have hiked rates.

On the other hand, with the country heading for a big economic contraction, the government and all businessmen would like RBI to reduce the policy rate. The economy has been falling steadily for two years even before the Coronavirus pandemic rolled into the country and RBI has done its bit for the government by cutting rates by 115 basis points in the last seven months. In May, it had cut Repo rates (the rate at which the RBI lends short term money to commercial banks) by 40 basis points.

Finally though, in August, the RBI and Das decided to neither cut rates (despite spiking inflation) nor reduce it (despite clamour from many to reduce it further to help save the economy). Das said that he would hold rates but the policy stance remains accommodative.

Das is not the only central banker facing tremendous pressure from governments to keep cutting rates and focusing on growth and job creation instead because of the economic devastation caused by the pandemic. Jerome Powell, head of the US Federal Reserve, announced a new approach saying he would tolerate inflation crossing 2% (the US central bank’s target) for short terms to focus on growth and jobs. Some central bankers have opted to hold rates at record lows despite rising inflation. The New Zealand central bank had already added jobs as a mandate two years ago.

The clamour for ignoring inflation, for the time being, is understandable. The lockdowns implemented by governments around the world to reduce transmission of the virus had disrupted supply lines – including the crucial farm-to-fork supply chain. Most economists agree that this is the main reason for the current spike in prices – and not excess liquidity or cheap money. The argument therefore, is that there is little that the central banks can do to damp the current price hikes. Once supply chains resume functioning smoothly, the inflation will come down. (In India, the fact that WPI is moving in the opposite direction to CPI bolsters the argument).

The issue here is that in the past too, central banks have often tried to boost growth and generate employment through monetary policy but the results have hardly been successful. Several decades ago, a rather simple reading of the Philips Curve developed by A.W. Phillips had convinced governments around the world that they could boost employment and job creation if they were willing to tolerate higher inflation. The central banks of many developed countries, including the UK, the US, and New Zealand had tried to use monetary policy to boost growth and reduce unemployment.

The problem is that it has not worked too well in the past and there is little evidence since its heydays that it will work any better now. The relationship between monetary policy and economic growth and job creation is not linear. The relationship of monetary policy with job creation/unemployment/wage levels is somewhat asymmetrical, as a lot of research shows. While a sudden tight monetary policy and high rates can create destruction of growth and jobs quickly, the reverse is not exactly true. Low interest rates and high liquidity may create jobs and economic growth but the results are much slower to come. There is a basic asymmetry in the relationship between sharp interest rate hikes and job losses vs sharp reduction in rates and job creation. A sharp drop in policy rates does not help if companies are not in a position to take cheap loans or banks are chary of giving them out because of other factors such as lack of demand, supply chain issues and the general condition of the balance sheets of corporations.

Donald T Brash, former head of New Zealand’s central bank, had presented a brilliant paper a couple of decades ago in the US where he recounted the efforts of his country to stimulate growth and employment. This happened throughout the 1970s and much of the 1980s. The experience was not pretty and inflation rose without helping jobs or economic growth much. Finally, the country’s central bank changed the objective of the monetary policy to price stability in the 1990s. Now New Zealand is again trying to use monetary policy for job creation and there is no evidence that this will succeed any better than in the past despite newer tools available to central banks around the world.

Binyamin Appelbaum who writes on economics for the New York Times (NYT) in his book The Economists’ Hour has examined the policies in the US which tried to do much the same as President after President tried to force the Federal Reserve chairman to try and create jobs while also containing inflation or even ignore inflation altogether. None of the efforts had happy endings.

Monetary policies do have a crucial role in economic growth and central banks can help by ignoring inflation and price stability for short periods to give a multiplier effect to other stimulus measures announced by the government. But it is a grave mistake to think that monetary policy alone can fix the economy, as governments often think.

Salvaging the economy ravaged by the pandemic is the government’s responsibility. It is not the job of the central bank. To paraphrase an old saying – the central bank can provide the water, but it is the government’s responsibility to bring the horse to it and make it drink.