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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