Central Banks: Challenges in Inflation Management Post-Pandemic

Central banks now face greater challenges in controlling inflation amidst globalization's decline and rising climate change impacts.

### The Evolving Landscape of Central Banking: Challenges and Lessons Post-Pandemic
* 🌈 The classic story of "The Wizard of Oz" reflects the **current monetary policy challenges** faced by central banks like the Fed, ECB, and Bank of England in the wake of the **Covid pandemic**.
* 📉 The pandemic led to severe supply shocks and government stimulus, resulting in **unexpected inflation**, which central bankers were initially **slow to address**.
* 📊 Although the Fed has successfully brought inflation back to a **2% target**, the long-term management of inflation remains **uncertain due to changing global dynamics**.
* 💰 The relationship between interest rates and economic activity illustrates how central banks **adjust rates to control inflation and unemployment**, akin to **manipulating a kite**.
* 🌍 The new risks of inflation stem from **supply shocks caused by geopolitical tensions and climate change**, shifting the focus from traditional monetary policy tools to **fiscal measures**.
* 🛠 As central banks navigate these challenges, there is a growing debate about the **need for new tools to maintain price stability**, which may fall **outside their traditional scope**.
* 💔 With rising unemployment and financial strain on consumers, the Fed's ability to generate a **"soft landing"** becomes crucial, reflecting lessons from past central banking **successes and failures**.
* ⚖ Ultimately, the future of central banking will require **collaboration beyond traditional roles**, as the landscape has shifted from **globalization to deglobalization**, with **climate change as a pressing factor**.

Somewhere over the rainbow. The Wizard of Oz, the classic children's story by Frank Baum, is partly about monetary policy. There's a famous moment where Dorothy's dog, Toto, pulls back the curtain and reveals the wizard to be just a man with a loudspeaker. In a way, the Covid pandemic and the inflation that followed has been a Wizard of Oz moment for the Fed, the ECB, the Bank of England, and other central banks. We thought they were maestros, all-powerful geniuses. Then came the Covid shock. The lockdowns of the pandemic caused severe supply shocks as factories shuttered around the world. Meanwhile, government stimulus meant to keep the economy afloat drove a surge in inflation. Central bankers were slow to recognize that inflation was taking off. And after it did take off, they didn't have the tools to bring it quickly under control. To the Fed's credit, when they decided they had to make this course

correction by raising rates rapidly. They did go for it. Powell was very clear that they will do whatever it takes to bring price stability back. I think right now many people thought that the Fed has redeemed themselves. But at the same time, the world has changed. Central banks have won the battle to get inflation back to their 2% target. In the years ahead, we may discover that they have lost the war over how management of inflation works. When interest rates go up, it becomes more expensive to borrow. And that means less spending, less demand, the economy cools, and inflation comes down. And when the problem isn't too much inflation, but rather too much unemployment, central banks do the reverse. They cut interest rates. They make it cheaper to borrow. And that increases demand, and it gets the economy going and creates more job opportunities. I would compare monetary policy, as the Fed manipulating a kite. Ultimately, it's at the end of that kite which really affects the economy.

In the U.S., to ensure that banks have enough money to cover withdrawals, they are required to keep some reserve cash with the Federal Reserve. The Fed's policy tool is an interest rate called the Federal Funds Policy Rate. And so by changing that fed funds rate level, it will affect the short-term interest rate that banks would charge at each other and eventually to other small businesses or large businesses. Central banks controlling the flow of credit has been the preferred method of governments to assure price stability for decades. But trade wars, actual wars, and climate change means the new risk to inflation comes from supply shocks. China's entry into the global trade system was a major disinflationary shock. That is not the world we are living in anymore. China is getting more expensive, and frictions between China and the United States means that globalization tailwind for disinflation is turning into a deglobalization driver of higher prices. We now live in a world of hot wars.

Russia invading Ukraine and turning off gas supplies and oil supplies for Europe, an expanding conflict in the Middle East. End of lockdown and inflation was amplified by higher energy prices, especially in Europe, but also around the world. Climate change is also part of the picture. Carbon taxes would help with the fight against climate change, but they would also be adding to inflationary pressure. The Fed's policy tools can only raise or lower aggregate demand. It is not meant to affect supply in the economy. So what can affect supply in the economy? Well, fiscal policy can tax policy can. So there's a big debate underway about what new tools are required to control prices and keep inflation low and stable. And many of those tools are being built outside of the remit of central banks. The pandemic economy has proved to be unlike any other. There remains much to be learned from this extraordinary period. One lesson for central banks is that keeping inflation on target is going to get tougher to do.

We've just been through a period where inflation didn't stay at that 2% target. And that's a world where the political support for strong, independent central banks is far from guaranteed. There are troubling signs that unemployment is starting to rise. And that means it's a turning point for the US economy and a turning point for the Federal Reserve. What happens to the status of the Fed under a second Donald Trump presidency? Would the Fed retain its strength and its independence, or would it find itself subject to greater political pressure to set monetary policy according to the electoral calendar? We estimate that 80% of the consumers are feeling financially stretched; people are paying well over 20% on the credit card bill. And so once the Fed starts cutting rates, then interest rates on the credit cards would come down. But at the same time, if the Fed generates a recession and if you lose your job, then how are you going to pay?

This is the reason why it's kind of critical for Powell to restore price stability and generate a soft landing. Since World War Two, the Fed had only been able to successfully generate a soft landing, perhaps once in 1995. Alan Greenspan was the Fed chairman. And then with Paul Volcker, he did exactly the opposite. He actually brought forth a very deep recession in the U.S. economy in the 80s. Yet he was still lionized for slaying the inflation dragon. The lessons from Volcker and Greenspan is that a central bank's reputation really depends on whether they prove to be steady, hands-on keeping price stability under control while allowing the economy to grow. And the unfortunate thing is I think Powell today still faces a tension between high inflation risks and also lower growth. We're living in a world which has swung from globalization to deglobalization, and where climate change is a new and important factor. I think in

the future, we're not going to be talking about maestros. And central banks might be the captain of the team, but they won't be the only player.

How Central Banks Won the Battle But Lost the War

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The Wizard of Oz and Central Banks' Monetary Policy

The Wizard of Oz moment parallels the Covid pandemic's impact on central banks, revealing their limitations in controlling inflation.

Supply shocks from lockdowns and government stimulus led to a surge in inflation, catching central bankers off guard.

While they have since raised rates to combat inflation, the long-term effectiveness of their management strategies remains uncertain.

The Role of the Federal Reserve in Managing Inflation

The Federal Reserve requires banks to keep reserve cash, using the Federal Funds Policy Rate to influence short-term interest rates.

Supply shocks from trade wars, conflicts, and climate change are now the main drivers of inflation, challenging the previous disinflationary trend.

The pandemic has highlighted the need for new tools outside of central banks to control prices and stabilize inflation.

The Federal Reserve's Challenging Landscape

The US economy is at a turning point, with rising unemployment and 80% of consumers feeling financially strained.

The potential for a second Trump presidency raises questions about the Fed's independence and political pressure on monetary policy.

Powell's challenge lies in restoring price stability and generating a soft landing, amid the conflicting risks of high inflation and low growth.

In the future, central banks will play a significant role but won't be the sole player in the financial system.

The traditional concept of maestros in finance is changing.

A more collaborative approach with multiple players is expected to emerge.