Monetary policy and inflation

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