The International Monetary Fund has urged central banks to avoid reacting too strongly to high-frequency movements in headline inflation, particularly when those movements are driven by volatile energy prices.
According to the Fund, they should, however, respond if higher inflation starts feeding into expectations or wage setting or if technology-driven activity starts strengthening pass-through from headline to core inflation.
“Where the post-pandemic inflation episode may have weakened confidence in the monetary policy framework, central banks should be quicker to respond to signs of such feedback from inflation to expectations or stronger pass-through. Indeed, not arresting a drift in inflation expectations in response to the current shocks can be costly when shocks of similar nature arrive in the future because it puts the credibility of monetary policy on the line”.
The Bretto Woods institution warned that should the adverse demand effects from the war or materialisation of financial risks eventually dominate—weakening growth materially, softening labor markets, and consequently reducing underlying inflationary pressures—scope for monetary policy to pivot toward easing could emerge. “Any such easing should be gradual and data dependent and remain consistent with returning inflation to target”.
Central Banks worldwide are engrossed with inflation targeting policy to address rising inflation. This is done by largely reducing money supply in circulation, but increasing the cost of borrowing.
The IMF continued that central banks should explain clearly how incoming data alter the balance of risks, what would justify a change in the policy path, and how they are distinguishing between first-round relative price effects and broader inflationary pressures.
This it believes can reduce the risk that households, firms, and financial markets will misread conditional policy guidance as unconditional promises.
With fiscal costs rising and electoral pressures intensifying in many countries, central banks may face renewed calls to accommodate higher public borrowing or tolerate inflation above target.
The Fund advised that ensuring legal and operational independence of central banks and shielding monetary policy from political interference and fiscal dominance are therefore essential.