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At their annual meeting in Jackson Hole last week, central bankers were lost in thought. At the 2022 meeting, when inflation is near a 40-year high, the message from monetary policymakers is simple: interest rates must go higher. This year, while inflation remains “too high,” in the words of Federal Reserve Chairman Jay Powell, higher interest rates have at least begun to dampen demand, and price growth is slowing. Instead, the discussion turned to the changing global economic landscape, from climate transition to geopolitical tensions. The message: Central banks are only going to get more complicated.
When monetary policymakers set interest rates to meet their inflation target, they must assess demand relative to supply. In short, raising interest rates helps cool an overheated economy if demand is expected to be higher than supply, and vice versa. However, economic turmoil has made this calibration more difficult.
The past three years have brought about substantial changes to the global economy. For example, the pandemic has left lasting scars, including higher levels of inactivity among British workers. Geopolitical turmoil is rewiring supply chains, and climate transition is driving major shifts in global energy markets. At the same time, an aging population, the AI revolution and growing demand for government spending add more dynamics, affecting both supply and demand. Powell described today’s rate setting as “navigating by the stars under cloudy skies.”
Another problem central bankers face is that interest rates affect demand with a long and variable lag, a blunt tool in times of rapid change. ECB President Christine Lagarde said in her speech: “For the situation we face today, there is no ready-made response strategy, so our task is to develop a new response strategy.” Central banks do need to adapt, otherwise they are inflation fighters reputation will be damaged. They should learn some lessons in doing so.
First, knowing when and when not to pay attention to economic models is critical. Because these are based on historical relationships, they become unreliable in the face of unprecedented events such as the COVID-19 pandemic, the war in Ukraine and Brexit. Lagarde acknowledged this, citing the Danish philosopher Søren Kierkegaard: “Life can only be understood backwards; life can only be understood backwards.” But it must be forwards develop”.
Second, central bankers need to improve their understanding of supply dynamics. Assessing the demand side – from consumer sentiment to credit conditions – is often easier than judging long-term changes in trade, energy and labor. For decades, globalization has supported the flexibility of supply and the free movement of goods, workers and capital. But new frictions could make supply less elastic and more volatile. Monetary policymakers need to draw on broader expertise and data sets to address these dynamics.
A better understanding of structural economic changes at home and abroad would help central bankers not only set current interest rates, but also raise them. It will also help answer the broader question of whether the 2% inflation target they have set is still valid in the long run. Even so, trying to control inflation through interest rates remains a complex endeavor, especially in times of economic “turn and crash,” in Lagarde’s words.
The biggest takeaway from this year’s Jackson Hole meeting should be that monetary policy in its current form has limited expected effects. Much deeper thinking is needed on how monetary instruments work. Without structural reforms to support supply, price volatility risks becoming the norm. That means governments need to step up, too.