Central bank policy aims to influence the money supply in order to achieve a desired inflation target. The most common monetary policy instrument is the central bank’s policy interest rate – the rate at which financial institutions borrow funds from the central bank (known as the discount rate in the United States). Some central banks also use open market operations to control liquidity conditions in the money markets and steer short-term rates toward their inflation targets.
Inflation is typically caused by supply shocks that push up the prices of commodities, energy, food and other goods and services. Research suggests that defusing such shocks before they turn into inflationary booms and busts is more effective than trying to prevent them in advance by attempting to stifle economic activity. Orthodox central banking practice is to provide massive infusions of liquidity to keep the financial and payments systems safe during such shocks, removing it as soon as they subside. This is the strategy that the Federal Reserve followed after Y2K and following the stock market crash of 1987 and tech boom and bust of the 1990s.
It is important for central bankers to balance price stability, output stabilization and employment goals. Even central banks that target only inflation — like the ECB and the Fed — acknowledge that they need to pay attention to employment in their dual mandate. A key challenge is to convince market participants that the central bank is credible about its long-run commitment to low inflation. This requires clear communication and a willingness to ease policy when needed.
About the Author
