The challenge of global disinflation

Central banks in much of the world are raising interest rates faster than would've seemed likely only a few months ago. Some analysts fear this multinational effort to curb inflation might tighten monetary policy too much. They note that any increase in rates involves a kind of spillover effect: It lowers demand not only for domestic output but also for imports. Failing to take account of this could cause an unintentionally sharp global downturn.

The issue will occupy finance ministers and central bankers gathering in Washington this week for meetings of the International Monetary Fund and World Bank. Might formal international coordination of policy be the answer? In an ideal world, it would be. In practice, it's unlikely to work.

In theory, the Fed and other central banks could take account of the spillovers from monetary policy by aiming, in effect, to manage global demand collectively. Now and then, they've tried — during the recession of 2008, for instance, and most famously in the 1985 Plaza Accord on exchange rates. Yet domestic concerns always dominated their calculations.

That's inevitable. Conditions vary widely from country to country and can shift abruptly, making genuine collective action next to impossible. Also, of course, politics is involved — not least thanks to the effect of fiscal policy on demand. How would international central-bank coordination deal with the intense downward pressure on sterling following the UK government's new confidence-sapping budget? How would it contend with the likely appointment of a new far-right prime minister in Italy, which has caused Italian bond prices to slump? How would it adapt to President Joe Biden's plan to forgive student debt, at a cost of some half a trillion dollars?

The most central banks can hope to do, while wrestling with such complications, is guide demand in their own economies. To be sure, this means judging whether and how far developments abroad will affect the calculation. Asked about this recently, Fed Chair Jerome Powell stressed that his officials stay in close touch with their counterparts abroad so they can monitor international financial conditions. Sharing data, carefully monitoring each other's intentions, and proclaiming the common goal of financial stability is as much as monetary cooperation can plausibly achieve. 

Fortunately, this should be good enough, so long as one other point is kept in mind. Monetary spillovers are a significant risk, and add to the uncertainty over how demand will evolve. This means that the Fed and other central banks must avoid getting locked into preannounced paths for interest rates. Rates will have to change when circumstances change, at home or abroad; central banks that lead investors to expect a certain schedule risk either eroding their credibility if they deviate from it or getting locked into the wrong policy if they don't.

In recent statements, the Fed has seemed to recognise this dilemma. It has promised to keep an open mind, judge policy according to incoming data, and stay nimble — all in the service of getting inflation back under control. If other central banks do the same, they should be able to steer through the current crisis, while avoiding anything worse.

Disclaimer: This article first appeared on Bloomberg and has been published by a special syndication arrangement.