Monetary policy: art or science?

BarcelonaThe science of monetary policy: a new Keynesian perspective. With this provocative title, one of Jordi Galí’s most celebrated articles started in the late 1990s. As he is a discreet person, he is surely not recognized enough at home. But it is a world reference. Every year his contributions to Neo-Keynesian theory and modern monetary policy attract economists from all over Barcelona to learn from the master.

In collaboration with other authorities in the field, it played a key role in defining the rule that central banks follow in trying to maintain price stability. To know when they need to stimulate the economy, or when it’s time to put the brakes on it.

The use of this rule was extended, to a large extent, by its simplicity. Only by looking at a variable, inflation, and with only one instrument, the very short-term interest rate, can central banks achieve their mandate. It is about raising rates when projected inflation rises, and vice versa. What a powerful weapon we thought we had at the turn of the century, when stability was the norm!

Now the weapon continues to work, but it is becoming increasingly difficult to use it properly. The sharp rise in inflation forecasts forces central banks to raise interest rates to curb the economy and ultimately moderate inflationary pressures. The ECB could end the year with the benchmark interest rate close to 1%, and the twelve-month Euribor could continue to climb to close to 1.5%. Thus, the pace of growth is sure to slow down sharply, and we cannot rule out that some countries will end up suffering a small recession.


IPC

(year-on-year variation)

INE (May)

Retail sales

INE (May)

CPI euro zone

(year-on-year variation)

Eurostat (May)

IPC

(year-on-year variation)

INE (June)

Underlying CPI

(year-on-year variation)

INE (June)

113,34 €

+44.81 € (yearly)

Retail sales

INE (May)

barrel of

petroli brent

(May)

146,05 €

+124.06 (yearly)

22.262.317

+16,373,416 (interannual)

future of gas

natural (1 mes)

(01/07/22)

Passengers at Spanish airports

AENA (May)

IPC

(year-on-year variation)

INE (May)

Retail sales

INE (May)

IPC

(year-on-year variation)

INE (June)

Underlying CPI

(year-on-year variation)

INE (June)

Retail sales

INE (May)

22.262.317

+16,373,416 (interannual)

Passengers at Spanish airports

AENA (May)

CPI euro zone

(year-on-year variation)

Eurostat (May)

113,34 €

+44.81 € (yearly)

barrel of

petroli brent

(May)

146,05 €

+124.06 (yearly)

future of gas

natural (1 mes)

(01/07/22)

GDP growth

(quarterly variation)

Idescat (1r trimestre)

Taxa d’atur

INE (1r trimestre)

Registered unemployed

Ministry of Labor (May)

Trade deficit

Idescat (March)

GDP growth

(quarterly variation)

INE (1r trimestre)

Taxa d’atur

INE (1r trimestre)

Registered unemployed

Ministry of Labor (May)

Social Security affiliates

Ministry of Labor (May)

Taxa d’atur a

the euro area

Eurostat (April)

Inflationary pressures should be considerably reduced. But in the current context there are two elements that make it extremely difficult to manage the situation, and which show that economics is not an exact science. The uncertainty surrounding any forecast is extremely high, a fact that conditions, and much, the performance of central banks. Decisions must be made based on projected inflation in the medium term, between one and two years, because that is when they have the most effect. That’s why they didn’t act when inflation started to pick up in late 2021. Back then it looked like the increase would be temporary. And that’s why they’ve made a substantial turn lately, when we’ve been seeing that the shock is more persistent.

Less agility

The second factor hindering the performance of central banks is that in recent years they have pledged to keep interest rates very low for a long time, and bought assets en masse in the financial markets. These are essential decisions to try to overcome with the fewest possible scars one of the worst shocks in decades but which have reduced the agility with which they have been able to respond to the change in economic context, sudden and unexpected, in recent months.

In the current context it has become clear that monetary policy is far from an exact science. That’s why, over time, we continue to learn when it has acted well and when it could have been done better. But we need to be cautious and measured by the criticisms we all too often make and that take advantage of information that those who, a few years or a few quarters ago, had to make decisions did not have.

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