Central Banking and Taming Inflation
The world’s central bankers recently gathered at the Jackson Hole conference, where they learned an interesting analogy about taming a horse. This analogy can be applied to central banking, and it provides valuable insights into how to manage inflation.
The Two Approaches to Taming a Horse
There are two ways to tame a horse, and these methods can be compared to the approaches central banks take to control inflation. The first approach is to break the horse with fear, which can be equivalent to raising interest rates to crush inflation. However, this method can have negative consequences, such as causing a recession. The horse may never forget the pain it experienced, and similarly, the economy may take a long time to recover from the harsh measures.
A Kinder Approach to Central Banking
The second approach to taming a horse is to set consistent boundaries with gentle consequences. This can be achieved through noisy clapping, which startles the horse but does not cause it harm. Martins Kazaks of the Bank of Latvia explains that this approach is similar to central banking. If everyone believes in the inflation target, then nobody will raise prices and wages too much in the first place. This means that the central bank can be gentler in its approach, as the boundaries are credible, and the economy is more likely to respond positively.
The Importance of Credibility
Credibility is key when it comes to central banking. If the central bank is seen as credible, then it can achieve its goals without having to resort to harsh measures. This is because the economy will respond to the central bank’s actions, and inflation will be kept under control. The central bank can set consistent boundaries and use gentle consequences to achieve its goals, rather than relying on fear and harsh measures.
The Role of Interest Rates
Interest rates play a crucial role in central banking. Raising interest rates can help to control inflation, but it can also have negative consequences, such as causing a recession. However, if the central bank is credible, and everyone believes in the inflation target, then it may not be necessary to raise interest rates as high. The central bank can use gentle consequences, such as small increases in interest rates, to achieve its goals.
Conclusion
In conclusion, the analogy of taming a horse provides valuable insights into central banking. The two approaches to taming a horse can be compared to the approaches central banks take to control inflation. While raising interest rates can help to control inflation, it is better to set consistent boundaries with gentle consequences. This approach requires credibility, and the central bank must be seen as credible in order to achieve its goals. By understanding the importance of credibility and gentle consequences, central banks can develop effective strategies for managing inflation and promoting economic growth.
