Globalization Monetary policy

Does central banks have the full ability to control inflation?

The central banks of major countries, in responses to the U.S. financial crisis, economic slowdown and sovereign debt criss in the euro zone, have provided unprecedented support to the global growth. The measures include zero bound policy interest rate, monetary quantitive easing, and in some cases government fiscal expansions.

These extraordinary actions have created positive, albeit not as much as hoped. The effect in reducing unemployment is noticeable such as in the U.S., however, the effect on price stability is hardly achieved. Inflation has been persistently below targets in the U.S., in the euro zone and in other major economies alike.

So do central banks have the ability to fully control inflation?

In a recent speech, ECB chairman, Mario Draghi said he “would dispute entirely the notion that (central banks) are powerless to reach (their) objective.” I think it is true that the central banks has the ability to control inflation, but we have to recognize the differences between responses of economic growth and those of inflation to the economic policies.

Draghi acknowledged a time delay between inflation with respect to economic growth. “To some extent this apparent disconnect between real and nominal developments is an expression of lags in the transmission process.” He said.

The difficulty in price control, I think, arises from that central banks having only one policy tool but two mandates, and these two mandates are not synchronized in timing. Inflation is often a consequence of economic growth and hence evolves with a delay with reference to the economic dynamics. The difficulty in inflation control is compounded by two additional factors. First, the benefits from the economic growth this time are used for paying down debt for consumers. For business, the profits generated from the growth are more used to make companies robust by piling cashes, or make dividend payments to shareholders, and less to expand business due to weakness in overall demand.

Second, in the globalization environment, strong connections are generated between economies in the other countries. Inflation in one economic area, is therefore affected by global factors outside the control of its central bank. Examples are slumps of commodity prices such as oil and base metals.

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