She view has been widespread among economists for decades that trust in the central banks’ promise of stability is the decisive factor in the fight against inflation. This view spread after attempts to forecast inflation using simple measures such as money supply or national debt failed.
Experience has shown that in quite a few episodes in economic history a strong expansion of the money supply was followed by inflation. In quite a few other episodes, however, inflation by no means followed growth in the money supply.
The relationship between money supply and inflation, which monetarists like Milton Friedman once believed to be very stable, has proven unreliable. Therefore, the attempt to control inflation primarily through the money supply has long been abandoned by monetary policy.
Playing with fear
The relationship between national debt and inflation is also not clear. There are many examples from Latin America, for example, in which high national debt led to inflation. But there are counterexamples such as 19th century Great Britain, which had high national debt for decades. This did not harm the status of the pound sterling as the leading currency in the world.
In the end, the decisive factor is whether the people involved in economic life, regardless of whether they act for companies or as members of private households, believe in the future stability of monetary value. If they expect a significant loss of their purchasing power associated with inflation in the future, they may feel compelled to give preference to spending on consumption or investment.
The sudden increase in macroeconomic demand caused by these pull-forward effects, if it encounters a less flexible macroeconomic supply of goods, can generate precisely the inflation that people feared. This is why the central banks have for decades made it very important not to fear an increase in the inflation rate.
What is the inflation target?
This is the purpose of the inflation targets that many central banks communicate to the public. Around 60 central banks around the world have set themselves such targets, mostly the target rate is at or near 2 percent per year. Central banks regularly review people’s inflation expectations with surveys of consumers, entrepreneurs and participants in the financial markets. If expectations remain stable near the official inflation target, it is said that inflation expectations are firmly anchored.
Such a monetary policy tries to influence the economy by changing the short-term key interest rate in such a way that the desired inflation rate is achieved. There is no active control of the money supply; rather, it is assumed that the money supply adapts to the needs of the economy through the demand for money and credit of the participants in the economic process.
This concept, which has kept the inflation rate at a very low level in many countries over the past few decades, has undoubtedly been very successful. But it has faced a number of challenges over the past few years. Initially, inflation rates in many countries remained below the target values, which need not pose any problems immediately, but has raised doubts about the ability of the central banks to increase inflation rates if desired.
The financial crisis of 2008 and 2009 showed how much central banks can be absorbed by the need to stabilize rapidly growing, dynamic and crisis-prone financial systems, especially in an environment of structurally low rates of economic growth and little confidence in the efficiency of expansionary financial policy. With extraordinary instruments such as extensive securities purchase programs, central banks facilitated the financing of states and companies, which went hand in hand with a significant increase in the share of debt in economic output in the world.
The pandemic has once again made clear the need for an expansionary monetary policy in severe crises, but it has also raised the question of how great the freedom of action of central banks is in the face of highly indebted national budgets and fragile financial markets if they had to respond to the threat of inflation by tightening their policies . The permanent anchoring of inflation expectations can turn out to be a monetary policy challenge.