To What Extent Should the Monetary Policies of Central Banks in Western Countries Differ or Resemble One Another as a Reaction to the Specific Causes of Inflation Facing their Economies?

Central banks such as the Federal Reserve in the U.S. and the Bank of England in the UK manage their nation’s macroeconomies with the goal of ensuring price stability and maximum employment. This is the best strategy a central bank can enhance to improve people’s wellbeing. The term price stability means that prices should not rise significantly (inflation), while also avoiding prolonged declines (deflation). Prolonged periods of hyperinflation or deflation can adversely affect an economy. Stable prices help the economy grow since jobs are protected and there is certainty that the value of money will be the same over time. As custodians of price stability, central banks lay the foundations for a healthy and stable economy. Τhe independence of central banks enhances their ability to maintain low inflation rates. If governments had central banks under their direct control, politicians might be tempted to change interest rates to suit their own policies in order to create a strong short-term surge in economic activity or to use central bank money to finance popular policy measures. This would damage the economy in the long run.

Globally, inflation rates are rising to levels not seen since the 1980s, particularly in the U.S. and European countries. What is unusual this time is that the advanced economies are at the forefront, with annual consumer price inflation in November 2022 at 7.1% in the United States, 10.1% in the Eurozone and 10.7% in the UK. Among emerging and developing economies, the traditionally resilient Asian economies also experienced high inflation, with inflation reaching 5.9%, 8.8% and 5.0% in India, Bangladesh and South Korea, respectively. In some cases, there are country-specific reasons for soaring inflation. In Turkey, President Recep Tayyip Erdogan is trying to run the central bank. Serious mismanagement of foreign exchange reserves and agricultural policies are to blame in Sri Lanka.

An important question that arises is related to the necessary mechanisms to fight inflation. Should the monetary policies of central banks in various Western countries differ or resemble one another as a reaction to the specific causes of inflation facing their economies? The answer to this question depends on the causes of inflation. However, are the causes of inflation the same in all countries?

Several arguments support that the causes of inflation are similar across the globe:

• The re-opening of economies after the coronavirus pandemic. As economies reopened, nothing returned to pre-pandemic levels. Globalization, as we had known it for more than 40 years, changed. A trend was reinforced towards a gradual abandonment of the strategy of European and US multinationals to seek to improve their competitiveness by creating global value chains (distribution of intermediate production to various, even very distant, territories, in order to reduce costs). The total value of these intermediate goods as a percentage of global exchanges is steadily declining, while the multinationals are seeking to overcome the obstacle of the long distance from the final consumer, which is a decisive factor for strategic industries. Several western companies are already taking an additional step: they are deciding to repatriate all their activities, now convinced that improving their competitiveness by automating production processes rather than using cheap labour will ultimately be more efficient. The occasion for the broader reflection on the need to organize another globalization – since complete de-globalization was considered technically impracticable and economically unfeasible – was the dangerous arrhythmia observed during the last epidemiological crisis in Europe and the USA, because of the excessive dependence of countries on foreign (mainly Chinese and Indian) production units for products critical to the health of their populations, such as medical and pharmaceutical products (masks, protective clothing, medicines), food, energy, etc. This was preceded by a particularly aggressive Chinese policy of penetrating western markets through the acquisition of strategic American and European companies, the value of which had fallen to extremely low levels as a result of the crisis.

There have been supply and demand imbalances, abrupt disruption and resumption of supply chains, severe weather events with major disasters in primary production, labour shortages due to reassessment of preferences, and goods being stuck in major ports. The pandemic has also changed the way we live and work and therefore the things we need. Consumers are buying certain products, such as electronics and supplies for home repairs, in larger quantities than the businesses selling them had planned. Important materials, such as semiconductors, are suddenly hard to find. All these developments have led to a reduction in the supply of goods of up to 50% compared to previous years.

At the same time, governments, in order to support businesses and households, have pursued a loose fiscal policy by making plenty of money available on the market. In the same vein, central banks kept interest rates low. Demand thus remained strong, despite supply problems. Moreover, in 2022, faced with the risk of another factory shutdown, all large firms began to build up inventories, further increasing demand. During the pandemic, consumption shifted from services to goods and, because goods production was less responsive to market changes (more “inelastic”), it could not expand fast enough. The result? Price increases, i.e. inflation.

• Higher energy prices push up inflation. Oil, gas and electricity have become more expensive around the world. Many factors are affecting energy prices: weaker winds in the UK have resulted in wind turbines not working, droughts in Brazil have led to less energy production from dams, and last year’s cold winter left us with lower oil and gas reserves. Combined with rising demand, all of this has caused prices to rise rapidly. Because much of business and people’s spending is energy-related, the price of oil, gas and electricity is of great importance to overall inflation: half of the recent increase in inflation was due to higher energy prices. Since they are influenced by so many things, it is not unusual for energy prices to show significant fluctuations.
• Russia’s war in Ukraine added more fuel to the fire of rising prices. Europe and the West in general were supplied with cheap raw materials from Russia (e.g. natural gas) and Ukraine (e.g. wheat). After the war, this is no longer possible. They therefore had to turn to other sources, much more expensive ones. But Russia’s aggression created an additional problem of trust and geopolitical risk. If other countries want to imitate Russia, e.g. China, what situation will Europe and the West find themselves in? Is it therefore better for the EU to find closer, even more expensive, raw materials?

The above shows that the main source of inflation today is not demand but supply, especially supply chain congestion and disruptions initially caused by the COVID-19 pandemic and exacerbated by the ongoing war in Ukraine. This implies that more aggressive moves by central banks to curb demand could well prove unnecessary, raising the risk of a severe downturn or even a recession. As former Fed Chairman Ben Bernanke and others showed in a 1997 paper, a significant part of the effect of oil price shocks in causing the three recessions between 1973 and 1991 did not come from rising oil prices per se, but rather from tighter monetary policy in response to the resulting higher inflation. Furthermore, inflation today is unevenly distributed across all goods and services, and price increases in a country cannot be controlled by simple exchange rate adjustments.

Better global monetary policy coordination is very important. These minimum measures are especially important in emerging economies in Africa, Asia, and Latin America, where inflation can push large numbers of vulnerable groups into extreme poverty.

The fact that the main cause of today’s price pressures comes from supply should not be taken to imply that demand has not played any role in western countries. If we remove food and energy prices, Eurozone inflation drops sharply from 10.1% to 6.6%, UK inflation drops from 10,7% to 6,3% while US inflation declines from 7.1% to 6%. Therefore, compared to the Eurozone, demand has played a greater role in the USA. Indeed, President Joe Biden’s administration has already implemented one of the largest federal spending programs in U.S. history – the $1.9 trillion U.S. Rescue Package, part of an overall pandemic stimulus package of almost 25% of GDP – to support the most vulnerable in society during the COVID-19 crisis. Therefore there is some room for differentiating monetary policies in western countries with the US’s monetary policy being more contractionary compared to the Eurozone’s and the UK’s.