Opinion: Why Central Banks Are to Blame for Inflation

The mandate of a central bank, as summarised by the International Monetary Fund, is to oversee and conduct monetary policy to achieve price stability (with the goal of low and stable inflation) and to manage economic fluctuations (IMF, 2006). Over the past year, however, the world inflation rate witnessed substantial growth—from 4.7 percent in 2021 to 8.8 percent in 2022 (Desilver, 2022). As expected, consumer spending—led by food and beverage, gasoline and motor vehicles—has declined for the third consecutive quarter ($14.1 trillion down $13.9 trillion) from the erosion of purchasing power and uncertain inflation expectations (IMF, 2022); a decline in competitiveness, higher exchange rates, and less attractive trade agreements has resulted in worsening trade finance; and central banks, through open market operations, have been forced to formulate new monetary and fiscal policies—either contractionary and expansionary—to combat the episode. While the motivation for making these policy decisions ranges from defending the value of the currency to maintaining financial and economic stability, the dominant inducement is to curb inflation, often deemed viable when inflation rises above its inflation target. Similar to many countries, the Federal Reserve System of the United States of America sets its inflation target at 2%; however, current estimates from the U.S. Bureau of Labor Statistics conservatively reports it at 7.1%. So why does such a discrepancy exist; how does it apply to other nations—both developing and developed—and how does this relate to the statement that central banks are indeed largely responsible–if not entirely accountable—to the current inflation episode. This research paper will discuss, analyze, and eventually answer these key issues.

Central banks have primarily contributed to the current inflation episode through their expansionary monetary policies. In the aftermath of the global financial crisis, many central banks implemented accommodative monetary policies, such as lowering interest rates and implementing quantitative easing measures, in an effort to stimulate economic growth (Cheng et al, 2021). While these measures may have helped stimulate growth in the short term, they also contributed to an increase in the money supply, which has led to higher prices when demand outstriped supply. In Zimbabwe, for example, a study using Autoregressive Distributed Lag (ARDL)— considered the best econometric evaluation method to capture short-run and long-run impact of independent variables—reveals how the monetisation of fiscal deficits (expansionary monetary policy) and the impact of the quasi-fiscal activities of the central bank has caused the country’s hyperinflation of 79 billion percent. For clarity, this study examines the relationship between the consumer price index and key variables (broad money supply, parallel market exchange rate premium, interest rate, output gap and lagged consumer price index) to determine the role of monetary policy in the hyperinflation episode for both the short and long run (Kavila, Roux, 2017). The study finds that expansionary monetary policy, the exchange rate premium and inflation expectations caused hyperinflation in Zimbabwe during the study period—a direct fault to the Reserve Bank of Zimbabwe (RBZ), the country's central bank. This data set is corroborated with other findings on causes of inflation in some African countries. In a study where they assessed whether Zambia is ready for inflation targeting, Simatele, Schaling and Alagidede (2015) found that inflation in Zambia was attributed to the monetisation of fiscal deficits, excessive money supply growth as well as exchange rate and supply side shocks. Akinbobola (2012) empirically analysed the impact of fluctuations in money supply and exchange rates on inflation in Nigeria and found that the expansion of money supply caused inflation in both the short and long run. He later concluded that his findings are applicable to other, more developed countries.

An alternative form of expansionary monetary policy is quantitative easing (QE), where central banks purchase securities from banks and other financial institutions with newly created money. This was especially prevalent during the COVID-19 pandemic where, in an attempt to maintain spending and investment levels while lockdown measures curtailed most economic activities, central banks bought government bonds. In 2020, the Bank of England (BOE) purchased £895bn of UK government bonds, the Federal Reserve System bought at least $500 billion in Treasury securities and $200 billion in government-guaranteed mortgage-backed securities in March, and, since November of 2020, the Reserve Bank of Australia has spent over $300 billion to “ease financial conditions set by the pandemic by lowering bond yields further out the curve and contributing to downward pressure on the exchange rate” (Reserve Bank of Australia, 2021). In fact, all major economies’ central banks used quantitative easing to increase the broad money supply in their respective economies (Lowe, 2020). Naturally, as the money supply increased faster than the rate at which goods and services are produced, a rise in prices was inevitable—due to greater capital available to bid up the prices of goods and services. QE also led to an increase in asset prices, such as stocks and real estate, further contributing to higher demand and prices as it encouraged households to increase wealth and confidence. 

Furthermore, the creation of excess money balances, mainly across financial institutions, resulting from the increase of broad money supply, translated to a significant rise in asset prices (equities and real estate) and subsequently strong recovery of aggregate demand. One must concede that this unconventional policy can be the right decision—proven to increase spending, increase employment, and reduce deflationary pressures in times of economic downturn or financial crisis—however, the COVID-19 pandemic was certainly not the time as it couldn’t address the fundamental economic issue (Barnett, 2022). Lockdowns, business closures and job losses rendered economic stimulation impractical, lower borrowing costs and increased credit failed to address the root cause of the downturn—the public health crisis—and both businesses and consumers, during the economic uncertainty and fear surrounding the pandemic, were hesitant to take on debt. Although central bank officials argued the transmission of QE was directed towards households and businesses (Federal Reserve Board, 2021), this was limited in times of stress as banks were hesitant to lend. Central banks, in the words of Mervyn King of the Bank of England, “lost control of inflation,” (Barnett, 2022) resulting in a monetary policy trap where central banks have been unable to withdraw the money it has created—thus, rising prices are attributed to the money in the economy that exceeds the available goods and services.

Another important factor to consider is imprecise inflation targets, set by central banks. Unsuccessfully adopted over 30 years ago by the Bank of New Zealand, (Carré, 2014) it should be a relic of a time gone by, rather than an anchor for monetary policy decisions. The increasing complexity of the macroeconomic environment, as well as the systems seemingly qualitative determiners, has perpetuated a system of imprecision, leading to greater uncertainty in the markets—further exacerbating inflation (Mulhearn, Vane, 2016, pp. 222). In some cases, the inflation target is outdated—such as the Federal Reserve System which has remained unchanged since 1996 at 2%. There, the inflation target fails to reflect the changing economic landscape—such as the effects of global economic events (e.g. COVID-19) which has remained stagnant to this day. Thus, two scenarios have been concurrent at the global level: gratuitous optimism and unjustified pessimism. In one, aggressive tightening leads to deflation and a severe contraction in economic activity. In the other, monetary stimulus leads to excess demand. Varied responses to inflation—especially inflation targeting—should also be mandated. Using a cross-country analysis where different patterns of rising consumer prices are analysed, inflationary factors differ widely among 2%-target-inflation nations. Using OECD-reported national CPI data  (constructed following the Classification of Individual Consumption According to Purpose [COICOP]), we can see how U.S. housing expenditures contribute 1 percentage point to the average overall inflation rate, which means that it accounts for 64% of the total 7.1% inflation rate. Meanwhile, in France, Germany and the U.K., the housing component constitutes 26%, 29% and 33%, respectively, of each country’s overall inflation rate, and in Japan it constitutes just 13%. For Mexico, Peru and South Africa, the OECD reports further disaggregated CPI and inflation contribution data for the housing, water, electricity, gas and other fuels expenditure category—noting a 49.3% standard deviation in that category. Yet, all these countries (and 12 more) follow a “universal” 2% inflation target. In other words, this supposed conventional wisdom has led countries to undertake policies in which they are unprepared. In addition, as Jeffrey Frankel argues in a Center for Economic and Policy Research column, “central banks that had been relying on [inflation targeting] had not paid enough attention to asset-price bubbles", and "inappropriate responses to supply shocks and terms-of-trade shocks" were rampant (Frankel, 2012). Both the former and the latter, to some extent, occurred concurrently during COVID, thus, reverberations in today's inflationary landscape have been demonstrated by inaccurate forward guidance as no clear and transparent framework exists for making decisions about monetary policy. Take China, a country with unique economic conditions and development stage. China has a large and rapidly growing economy, thus its inflation target of 3% is justified—appropriate for maintaining price stability and supporting economic development. Furthermore, China has a high level of savings and a low level of household debt, low labor costs and is relatively efficiency in its production and distribution systems (Cheng, 2022), all of which are indicative of a lower inflation target; yet, it takes into account the slightly volatile price-stability the nation has demonstrated in the past (such as from the zero-COVID policy). Thus, in a volatile global stage, China boasts the lowest and, more importantly, most stable (Tang, 2022) inflation rate in the world—a testament to its “flexible inflation targeting” where employment, output, and financial stability are key factors in determining targets, as well as its scare manipulation of interest rates—a topic which we will discuss next.

By far the most common response to inflation is raising interest rates. Contemporary economic theory assumes that raising interest rates reduces growth in aggregate demand in the economy, which leads to lower inflation. This rests on demand-pull effects, which suggest that raising interest rates reduces consumer spending and investment as borrowing costs increase and saving becomes more attractive. The increase in saving reduces the supply of money in circulation, curbs inflation, and increases the value of the currency. Appreciation of the currency hurts the export sector and eases potential wage pressures since labor demand declines as a result of reduced competitiveness for local tradable goods and services. However, this logic may be flawed. External economic factors from the magnitude of the interest rate increase to the low degree of flexibility in the economy, and the unresponsiveness of firms to changes in costs, challenges that perhaps cost-push effects could arise instead of demand-pull. We can investigate this by looking at a study conducted by Jón Helgi Egilsson which models how the exchange rate might respond to a lasting interest rate differential (IRD). If the exchange rate appreciates, more expensive imported goods have led to cost-push inflation. On the other hand, if the exchange rate depreciates as a result of the IRD, competitive exports and domestic aggregate demand increases indicate demand-pull. To set conditions, the production function would have a cash-in-advance (CIA) constraint, since we assume that production output must be funded before the product is sold; firms are assumed to maximize profits; labor markets are interlinked, and prices and factors of production are constrained by international price gaps (Egilsson, 2020). In his study, he concludes that from 2019, exchange rates have appreciated from IRD—reflecting a cost-push effect. Thus, increasing interest rates, while tempting in the short run, should not have been the main policy of central banks as it is counterproductive—failing to address the factors that are causing the increase in production cost—and has led to a lack of competitiveness at an international scale (the influx of foreign capital into countries yielded greater valued currency from higher interest rates; as country's exports are denominated in its own currency, then an appreciation of the currency made those exports more expensive for foreign buyers. This led to a decrease in demand for the country's exports, which can hurt the country's trade balance and ultimately lead to a slowdown in economic growth.) In addition, central bankers have also been reluctant to admit they made errors in keeping interest rates too low, for too long. For example, a study in 2014 concluded that 31 countries increased interest rates too quickly after a period of negative rates, leading to an uncontrolled increase in demand and therefore inflation (Lee, Werner, 2014). Furthermore, central banks have been slow to react to rising inflation. For instance, since the CPI data release in early fall last year, the Fed pivoted toward rapidly removing policy support only in late November and did not raise rates until March. Action must instead be taken quickly to avoid building up inflationary inertia and a stagflation scenario, as happened in the 1970s.  

Central banks globally should evaluate new, innovative strategies to combat inflation. Given globally high public debt levels and fiscal dependence of central banks, budgetary adjustment is even more urgent than monetary policy tightening. It allows monetary policy manoeuvrability and defends central bank independence. Fiscal adjustment measures must be country-specific and should include both increases in revenue and reduced expenditure. Ideally, such measures should help address long-term development challenges. For example, higher retirement ages and green taxation could reduce fiscal deficits, mitigate the adverse effects of population aging and limit carbon emissions. Fighting inflation in the environment of adverse supply shocks must involve economic and social costs, but postponing disinflation or adopting half-measures will be even more costly. Governments should avoid populist measures such as price controls or direct or indirect subsidisation of those goods and services (for example, energy), for which prices are rising rapidly.

In conclusion, it is important to recognize that the central banks do not operate in a vacuum. They are influenced by a variety of external factors such as economic growth, consumer demand, and the state of the labor market. Supply-side factors such as lockdowns—which have disrupted global, regional and local supply chains—have limited the supply of certain critical goods and production inputs and contributed to their higher prices. The increasing tensions in the international trading system, such as the ongoing US-China trade conflict and various protectionist measures in response to the pandemic, have not helped eliminate production and supplied bottlenecks. The war in Ukraine, sanctions against Russia, and Russia’s retaliatory measures have caused further increases in prices of energy, food, metals, and several other inputs. However, this is diminutive compared to the lack of transparency, accountability and significant corruption in central banks in developing countries (primarily Bangladesh, Venezuela, Libya, Afghanistan, and Iraq, according to a 2021 report). In developed nations, despite changing macroeconomic landscapes, a continuation of ultra-soft monetary policies, the massive asset purchase programmes, and expansionary fiscal policies has led to immense inflation which will persist beyond 2022 (given still-high money supply growth rates and likely gains in the velocity of money) and further squeeze real incomes. For that, central banks have no one to blame but themselves.