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posted on 13 November 2016

How Do Central Banks Typically Control Inflation?

from the St Louis Fed

Many central banks around the world are experiencing inflation below their targets, despite having implemented low-interest-rate policies and various unconventional monetary policies in recent years. An article in The Regional Economist explains the origins of conventional central banking practice for managing inflation and explores an alternative solution to the problem of too-low inflation.

Money Growth Targets

Vice President and Economist Stephen Williamson explained that monetarist ideas and experience implementing those ideas in the 1970s and 1980s drove two key developments in modern central banking:

  • The recognition that the central bank is responsible for inflation.

  • The recognition that the central bank’s main instrument for monetary control is a short-term nominal interest rate.

He noted that monetarism is best represented in the work of economist Milton Friedman. Friedman suggested that the best approach to inflation control is for the central bank to conduct monetary policy in such a way that a specified measure of the money stock in circulation would grow at a constant rate.1 Under this approach, a higher desired rate of inflation would be associated with a higher constant money growth rate.

Many central banks adopted money growth targets during the 1970s and 1980s to combat the relatively high inflation rates of that era. In fact, during his tenure as Fed chairman (from 1979-1987), Paul Volcker brought inflation down from about 10 percent to about 3.5 percent through a reduction in the money supply growth rate.

While the constant-money-growth prescription helped reduce the high rates of inflation in the 1970s and 1980s, Williamson noted that it didn’t work as an ongoing approach, as the relationship between money growth and inflation became much more unstable. Consequently, central banks had to use a different approach to managing inflation over the long term.

Inflation Targets

Many central banks have since adopted explicit inflation targets. To move inflation toward the target, central banks typically rely on an overnight nominal interest rate. In the U.S., for example, the Federal Open Market Committee targets the federal funds rate.

Williamson wrote: “Conventional central banking practice is to increase the nominal interest rate target when inflation is high relative to the inflation target and to decrease the target when inflation is low. The reasoning behind this practice is that increasing interest rates reduces spending, ‘cools’ the economy and reduces inflation, while reducing interest rates increases spending, ‘heats up’ the economy and increases inflation."

However, what if central banks could increase inflation by raising - rather than cutting - their nominal interest rate targets? This is the key Neo-Fisherian principle, which will be examined in the next blog post.

Notes and References

1 See Friedman, Milton. The Counter-Revolution in Monetary Theory. London, U.K.: Transatlantic Arts, 1970.

Additional Resources

Source

https://www.stlouisfed.org/on-the-economy/2016/november/how-central-banks-typically-control-inflation

Disclaimer

Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.

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