Central banks are doing more harm than good as they seek to control inflation

Raising interest rates to control inflation is too blunt a weapon to aim at the fragile global economy, and risks triggering another recession
Central bank policy needs to embrace the bigger issues of social deprivation and welfare needs

David Brown

Published: 3:30am, 17 May, 2022

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Central banks are moving towards tougher interest rate tightening, but at what cost? They are on a quest to rid the world of higher inflation, but are they driving the global economy into needless recession in the process?

They may be our chosen champions against spiralling inflation, but central banks’ job is not to achieve price stability at any cost, not least another recession so soon after the 2020 Covid-19 downturn and while the Ukraine conflict threatens even more turmoil.

The US Federal Reserve and the UK’s Bank of England, among other central banks, may be stepping up their interest rate responses, but is higher inflation really the major worry? The world faces so many challenges right now, it begs the question whether targeting 2 per cent inflation is still appropriate. There’s a stronger moral argument for monetary moderation and letting global fiscal reflation take the strain instead.

If global policymakers learned one key lesson from the 2008 financial crash, it might have been that the rush into fiscal tightening before the world had time to recover fully caused needless damage to global recovery.

The legacy of sub-par economic growth and heavy structural unemployment left the world overexposed to the Covid-19 pandemic and its aftermath in terms of output volatility, supply-chain shortages and rising inflation risks. The Ukraine conflict couldn’t have come at a worse time for policymakers, struggling to cool demand and contain the risks to inflation from interest rates which remain far too low.

The challenge now is finding a middle road which keeps global recovery on track while keeping a lid on inflation, without causing any more damage along the way.

Global growth is slowing and the worry remains that it won’t take much more to tip economic confidence over the edge into another downturn. Energy and commodity prices have surged, consumer spending is being hit hard by cost-of-living increases, and businesses are delaying new investment in view of the uncertain outlook.

Forecasters are slashing expectations for global growth, with the likelihood of further downgrades to come, especially if central banks escalate their fight against inflation. Using higher interest rates to control inflation is too blunt a weapon, which could easily break the back of global growth at the worst possible time.

Targeting a 2 per cent rise in consumer price indices (CPIs) might have been suitable during periods of high growth and low inflation, like in the 1990s and 2000s, but it seems out of place while the pandemic is still at large, there are contingent risks to growth and jobs, debt levels are high, and poverty, hunger and homelessness abound around the world.

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It is worrying to hear the contention by some monetary experts and former central bank officials that a recession might be required to squeeze higher prices and wages out of the system. Nobody wants a recession – least of all the less well-off in society, who would be hit hardest.

It raises the question of whether we need a change in central bank thinking: a more multifaceted approach to monetary policy which transcends the traditional reliance on interest rates to get the job done. The Fed is targeting 2 per cent inflation within the context of sustainable growth and job creation, but the range of policy considerations need to be extended into broader socio-economic parameters.

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Central bank policy has to move away from narrow inflation targeting and embrace the bigger issues of poverty, social deprivation and welfare needs. Climate change should be factored into the monetary equation at some future stage.

There also needs to be much closer co-ordination of monetary and fiscal policy to optimise economic potential in the context of improving social needs. The Fed may be heading back towards benchmark interest rates of 3 per cent, possibly higher, but there’s more work to do on encouraging bigger budgetary reflation, especially when the impact of US President Joe Biden’s fiscal regeneration programme may be losing momentum.

Central banks need to adapt to change before their monetary independence comes under closer scrutiny. Targeting 2 per cent inflation might have been sufficient in the past but it is a standard that is increasingly out of touch and needs to change. We need a complete overhaul of global monetary policy priorities and for central banks to work more effectively for all in future.

David Brown is the chief executive of New View Economics