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Monetary policy and inflation
Apr 02,2023 - Last updated at Apr 03,2023
As it is well known, any monetary authority has several objectives to achieve, including price level stability (inflation), economic growth, exchange rate stability, banking sector soundness etc. Most of the time, these are mutually exclusive; i.e., can’t be achieved simultaneously. Furthermore, objectives’ priorities differ from country to country depending on each state’s economic situation.
Usually, monetary policy is countercyclical; i.e., in an economic downturn, it must have a stimulating (expansive) effect on the economy and in a boom, it must act as a brake (restrictive). Most monetary authorities around the world use interest rates as the main tool to smooth the business cycle in order to prevent recessions or the overheating of the economy.
Overheating the economy is simply a recipe for inflation. When an economy is operating at its full/near full employment and spending is accelerating faster than supply, inflation is imminent. Therefore, some might jump to conclude that it is simple, just raising interest rates will cool down the economy and will combat inflation! For sure, if that is the only cause of inflation. But, is that the only cause of higher rates of inflation? Of course not. Imported inflation (in particular in small open economies), higher cost of production, supply chain delays, natural calamities, all could cause higher rates of inflation.
Therefore, for any monetary authority, it is crucial to dig deep, analyse and disentangle the root causes of inflation before it designs and implements its monetary policy. For example, if inflation is mainly caused by higher prices of imports (like food and energy) or supply chain delays, increasing interest rates is not the remedy. In fact, it might slow down the economy and might drag it into stagflation if the monetary authority is very aggressive.
This is evident in the United States. The Federal Reserve (the Fed) has been very aggressive to bring down inflation rates over the last 12 months but it didn’t succeed as it wishes. Why? Because inflation in the US economy is not totally driven by accelerating domestic spending. Inflation at the pump and the grocery store have been fuelled by events outside of the Fed’s ability to control. Therefore, many economists are calling the Fed to stop raising the interest rate, the federal funds rate and even must immediately reduce it. At the same time, they credit authorities for its proactive supply side policy to help reduce energy and food prices.
In Jordan, the situation is quite different. Economic growth has been anemic since the Global Financial Crisis, domestic spending is weak, unemployment rate has been consistently over 20 per cent. Accordingly, the latest inflationary pressures in Jordan (although modest) have been driven by higher international energy and food prices. If economic growth is the only objective for the monetary authority, reducing interest rates would be the ideal policy. But, the Central Bank is juggling many balls at the same time: Including exchange rate stability, price stability and economic growth; surely with different priorities than the United States. Obviously, this is a very challenging task. Given this fact, somebody must acknowledge the Central Bank’s prudent monetary policy to strike a balance between these main objectives.
The writer is former senior economist at International Monetary Fund