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17/09/2020 09:00:47 PM

THE PRIMARY OBJECTIVES OF ALL CENTRAL BANKS

Central bankers work to reduce the volatility of the economic and financial systems by pursuing five specific objectives:

  • Low and stable inflation
  • High and stable real growth, together with high employment
  • Stable financial markets and institutions
  • Stable interest rates
  • A stable exchange rate

Instability in any of these – inflation, growth, the financial system, interest rates or exchange rates – poses an economy wide risk that individuals can’t diversify away. The job of the central bank is to improve general economic welfare by managing and reducing systematic risk.  That is probably impossible to achieve all five of the central bank’s objectives simultaneously. Trade-offs must be made.

Low, stable inflation: Why have to stable inflation?

The director of research of the International Monetary Fund, Kenneth S. Rogoff., summarized virtually every economist’s view when he said, “Uncontrolled inflation strangles growth, hurting the entire populace, especially the indigent”. That is why many central banks take as their primary job the maintenance of price stability. That is, they strive to eliminate inflation. The consensus is that when inflation rises, the central bank is at fault.

The rationale for keeping the economy inflation free is straightforward. Standards, everyone agrees, should be standard. The purchasing power of one dollar, one yen, or one euro should remain stable over long periods. Maintaining price stability enhances money’s usefulness both as a unit of account and as a store of value

Prices are central to everything that happens in a market-based economy. They provide the information that individuals and firms need to ensure that resources are allocated to their most productive uses. When a seller can raise the price of product, that is supposed to signal that demand has increased, so producing more is worthwhile. But inflation degrades the information content of prices.

If the inflation rate were predictable, we might be able to adjust. But, as inflation rises, it becomes less stable. The higher inflation is, the less predictable it is, and the more systematic risk it creates.

High inflation is bad for growth. In such cases of hyperinflation – when prices double every two to three months – prices contain virtually no information, and people use all their energy just coping with the crisis, so growth plummets.

Because low inflation is the basis for general economic prosperity, most people agree that it should be the primary objective of monetary policy. But how low should inflation be? Zero is probably too low. There are a couple of reasons for this. First, if the central bank tries to keep the inflation rate at zero, there is a risk of deflation – a drop in prices. Deflation makes debts more difficult to repay, which is increases the default rate on loans, affecting the health of banks. Second, if the inflation rate were zero, an employer wishing to cut labor costs would need to cut nominal wages, which is difficult to do. With a small amount of inflation, the employer can simply leave wages as they are, and worker’s real wages will fall. So a small amount of inflation makes labor markets work better, at least from the employer’s point of view.

High, stable real growth

Central banks mission also is foster maximum sustainable growth in output and employment. That means they work to dampen the fluctuations of the business cycle. Booms are popular, but recessions are not. In recessions, people get laid off and businesses fail. Without a steady income, individuals struggle to make their auto, credit card, and mortgage payments. Consumers pull back, hurting businesses that rely on them to buy products. Reduced sales lead to more layoffs, and so on. The longer the downturn goes on, the worse it gets.

By adjusting interest rates, central bankers work to moderate these cycles and stabilize growth and employment. In recessions, the economy stalls, incomes stagnate, and unemployment rises. By lowering interest rates, monetary policymakers can moderate such declines.

Similarly, there are times when growth rises above sustainable rates, and the economy overheats. A period of above-average growth has to be followed by a period of below-average growth. The job of the central bank during such periods is to raise interest rates and keep the economy from operating at unsustainable levels

In the long run, stability leads to higher growth. The reason is that unstable growth creates risk for which investors need to be compensated in the form of higher interest rates. With higher interest rates, businesses borrow less, which means that they have fewer resources to invest and grow. The greater the uncertainty about future business conditions, the more cautious people will be in making investments of all kinds.

The importance of keeping sustainable growth as high as possible is hard to overstate. The difference between an economy that grows at 4 percent per year and one that grows at 2 percent per year is the difference between an economy that doubles in size over 18 years and one that grows by less than 50 percent in the same period. Keeping employment high is equally important. It is impossible for the economy to recover what unemployed people would have produced had they been working during a downturn. You can’t get the lost time back.

The levels of growth and employment aren’t the only things of importance, though. Stability matters too. Fluctuations in general business conditions are the primary source of systematic risk, a kind of risk that can’t be diversified away. Uncertainty about the future makes planning more difficult, so getting rid of uncertainty makes everyone better off

Financial system stability

Financial and economic catastrophes are not limited to history books. Financial system stability is an integral part of every modern central banker’s job. It is essential for policymakers to ensure that the markets for stocks, bonds, and the like continue to operate smoothly and efficiently.

If people lose faith in financial institutions and markets, they will rush to low-risk-alternatives, and intermediation will stop. Savers will not lend and borrowers will not be able to borrow. Getting a car loan or a home mortgage becomes impossible, as does selling a bond to maintain or expand a business. When the financial system collapses, economic activity does, too.

The possibility of a severe disruption in the financial markets is a type of systematic risk. Central banks must control this risk, making sure that the financial system remains in good working order. The value at risk, not the standard deviation, is the important measure here. When thinking about financial stability, central bankers want to minimize the risk of a disaster and keep the chance of maximum loss as small as possible

Interest-rate and exchange-rate stability

Keeping interest rates and exchange rates from fluctuating too much are secondary goals to those of low inflation, stable growth and financial stability. Interest-rate stability and exchange-rate stability are means for achieving the ultimate goal of stabilizing the economy; they are not ends unto themselves.

It is easy to see why interest-rate volatility is a problem. First, most people respond to low interest rates by borrowing and spending more and vice versa. So, by raising expenditure when interest rates are low and reducing expenditure when interest rates are high, interest-rate volatility makes output unstable. Second, interest-rate volatility means higher risk - and a higher risk premium - on long-term bonds. Risk makes financial decisions more difficult, lowering productivity and making the economy less efficient.

Because central bankers control short-term interest rates, they are in a position to control this risk and stabilize the economy

Stabilizing exchange rates is the last item on the list of central bank objectives. The value of a country’s currency affects the cost of imports to domestic consumers and the cost of exports to foreign buyers. When the exchange rate is stable, the prices of products produced in foreign countries are predictable, making it easier for the foreign manufacturer, the domestic retailer, and the buyer. Planning ahead is easier for everyone

Different countries have different priorities. While Fed may not care much about exchange-rate stability, the heads of central banks in small, less developed, trade-oriented countries do. In emerging market countries, exports and imports are central to the structure of the economy; officials might reasonably argue that good overall macroeconomic performance follows from a stable exchange rate.