The central bank isn’t just the boss of the economy. It’s just one dial on a big machine, and its job is to adjust the interest rate to change demand. But the economy isn’t just about demand. Half of inflation is due to supply issues: oil pipelines, droughts, diseases, and shipping issues. The key is that the central bank controls the interest rate, which has as much effect on output as a thermostat has on a fire outside a window.
This explains why monetary policy sometimes works beautifully and sometimes doesn’t work at all.
One Lever, Half the Problem
The main instrument the central bank employs is the interest rate. Increasing it means people will be charged more to borrow, which will reduce spending. Reducing it means people can borrow at lower rates and will thus spend more. It is all based on one single lever – the demand in the economy.
This is a brilliant strategy if the inflation is demand-driven. If there is too much money in the economy and not enough to spend, reducing demand is the best way to curb inflation. It is simple and straightforward.
However, the main problem is the capacity side. When inflation is caused by flow constraints, such as rising oil prices, crop failures, or factory closures due to sanctions, interest rates do not really come into play. Increasing them will actually make the situation worse, as it will first affect businesses with higher resource costs, then with higher credit costs.
Two Economies, One Tool
Demand Factors – under the control of the central bank. The central bank determines the price of money. When borrowing money is costly, people consume less, businesses delay investment, the housing market slows, and banks reduce lending. The value of money changes in line with differences in interest rates, and what the central bank says affects inflationary expectations.
Supply Factors – outside control of the central bank. Energy prices are tied to geopolitics and OPEC+/Coalition decisions. Weather affects harvests. Supply chains are disrupted by issues at ports, logistics, and sanctions. Labor productivity changes gradually over a long period of years. Trade barriers are a policy decision made in parliaments and presidential offices, not in central banks. A major breakthrough or failure in artificial intelligence or semiconductor manufacturing can shift prices in many industries in a single night.
Signals That Guide Rate Decisions
When the central banks meet, they don’t make rate decisions based on gut feelings. Instead, they consider key signals to determine the direction the economy is moving.
- The labor market is the starting point. If employment is rising, and unemployment and wages are increasing, it could mean higher inflation.
- The housing market moves in sync with interest rates, making it an early indicator of the impact of rate decisions.
- Consumer behavior reinforces these signals. If retail sales and confidence are rising, it means consumers are still spending. If not, it could be a bad sign.
- Business behavior gives a glimpse of what lies ahead. It includes PMI and investment plans, which indicate what businesses think about the economy.
- Credit conditions indicate the transmission of rate decisions. If credit growth slows down, it means financial conditions have tightened.
Lastly, there are expectations. It includes market expectations and what consumers and firms think about inflation, which central banks try to influence.
Central banks look at both demand and output to gauge where inflation is headed.
In terms of demand, they look at consumer confidence, sales, and jobs. If unemployment is low and wages are rising, people tend to spend more, which drives inflation higher. In turn, they raise interest rates to curb inflation.
In terms of resources, they look at producer prices and availability chain performance. If supplier prices rise faster than the people pay for goods, they will, in turn, pass those costs on to customers, driving inflation higher.
The other measure they look at is the output gap, or the difference between what an economy is producing and what it could produce at full capacity. When an economy is running above capacity, inflation rises. When an economy is running below capacity, growth slows, and inflation rises more gradually. This is an important measure in the policy models of major central banks, such as the Fed, the ECB, and the Bank of England.
From Data to Policy Decisions
Central banks do not adjust interest rates in a single day. Instead, every interest rate decision is made through a specific process that is initiated weeks before the meeting.
- First, there is data collection. Policymakers gather data from various official sources, business, bank, and market data, and sometimes other sources. The idea is to get a live view of the economy.
- Second, inflation analysis. Economists examine different measures of inflation, such as core and headline inflation. They look at different groups such as services, goods, energy, food, and more. The idea is to look for consistent trends in inflation. Economists do not look for short-term trends.
- Third, macroeconomic modeling. Economists use large models such as DSGE or VAR models. They use these models to run scenarios and prognose the economy.
- And finally, the decision-making stage. Policymakers vote on the interest rate. However, the vote is not what matters. The statement and the press conference are equally important. Policymakers use these tools to communicate with the market.
An important aspect of interest rate decisions is the difference between core inflation and headline inflation. Policymakers look at core inflation because it excludes volatile items such as food and energy. Food and energy inflation are usually driven by supply factors outside the control of monetary policymakers. If policymakers react too strongly to these factors, they risk slowing the economy for reasons beyond their control.
Inflation Beyond Central Bank Control
However, not all price increases can be managed through interest rates. A great deal of the cost pressure comes from factors outside the central bank’s direct control.
One of the main points here is energy. This is perhaps the clearest example. When oil products are disrupted, whether due to a cut in oil production or geopolitical tensions, oil prices rise across the economy. There is nothing a central bank can do to increase oil production; it can at most decrease the availability of goods, which will also reduce growth.
Another factor is global supply chains. Disruptions in the production or transport of goods also drive up costs, regardless of interest lending conditions. Even if interest cuts are low, supply chain issues will keep inflation high.
Food prices also behave similarly. Weather, geopolitical events, and agricultural cycles have a big impact on food values. These are structural issues, outside of interest hikes.
Trade policy is another factor. This directly affects the cost of goods, as tariffs and sanctions drive up import costs. Budget policy, when at odds with monetary policy, can cancel out the effects of interest rate decisions.
Lastly, long-run structural factors matter. Productivity and demographics affect economic growth. An aging population or a lack of productivity will affect input costs, and these factors change very slowly, far outside of interest ratios.
The Lag Effect: An Explanation
The effects of monetary policy are always delayed. It takes 6-18 months for changes in interest levels to be felt in the economy.
On the other hand, cost shocks have immediate effects on expenses. Therefore, when policy interventions are implemented, they may not work as well due to a change in the original conditions.
From Shock to Inflation Spiral
Supply shocks cannot be controlled by central banks, but they respond to their aftermath. Valuations rise, as in the case of oil, and so do costs. This, in turn, leads to a rise in wages, and businesses raise their costs to match the increases.
This is known as a wage-price spiral. Central banks do not directly address production disruption, but they try to prevent them from causing sustained inflation.
Turning Macro Signals into Trades
The key question for a trader is how to distinguish between demand-driven inflation and inflation driven by external factors.
If a data release is out on CPI, analyze its structure. If inflation is rising due to increases in core components of the release, then there is strong demand and therefore a greater chance of policy tightening. This is good for the currency and bad for bonds.
If inflation is driven by food and energy items, then the reaction is not as strong because central banks tend to ignore these.
It is also important to listen to what central banks are saying. If they say “transitory,” then there is inflation driven by production constraints, and therefore, no step is expected from the central bank.
The difference between headline and core inflation is another useful indicator. A large difference is a sign of externally driven inflation. A decrease in the difference is a sign of a broadening of inflation.
A day before a major data release, the key question is whether inflation is driven by demand or supply.
