The duty of a central bank is to pursue monetary stability — customarily defined by low inflation and steady output growth. Recent inflation levels have run larger than ever in the last half-decade (Desilver, 2022). In response, central banks across the world are synchronously hiking interest rates without
consulting each other (Moschella et al., 2022). This raises the question: what is the most effective way for Western central banks to tame inflation while limiting recessionary forces globally?
To answer, this essay makes three observations:
1. Owing to increased integration, trade flows, and global value chains, inflation operates on an international scale.
2. Given Observation 1, most integrated economies face similar inflationary threats, and all have incentive to individually tighten their monetary policies.
3. When Observation 2 occurs, and central banks amplify each other’s policies without cautious cooperation, negative spillovers are created while a resulting mutually damaging cycle feeds both inflationary and recessionary forces.
Taking these three observations together, this essay concludes that it is uneconomical for monetary policies to differ but dangerous for monetary policies to blindly match one another. Monetary policies should resemble each other only to the extent that they are carefully calibrated and driven by central bank cooperation.
Globalized Inflation
The Global Slack Hypothesis postulates that “domestic inflation rates have now become more a function of global, rather than domestic economic conditions'' (Milani, 2009). Using the Phillips Curve, analysts find that global slack — unused economic resources — is as important as domestic slack in forecasting short-term inflation dynamics (Wynne, 2009; Borio et al., 2007). This is also considered an openeconomy extension of the traditional closed-economy Phillips Curve (Garcia, 2012). When exchange rates are included in an open-economy model, the Philips Curve flattens, indicating that individual central banks hold less policy control over inflation behavior (see Figure 1, IS vs. RX curve).
In recent years, a scholarly consensus has agreed that globalization has a wide impact on nearly all economic activities (Frankel, 2000). In the United States, imports as a share of GDP increased from 4% in 1950, to more than 18 percent today (Wynne). In the E.U., imports as a share of GDP have grown from 20% in 1970 to over 46% in 2021 (World Bank). This means that the final consumption basket of an average citizen consists of both foreign and domestic goods, making global inflation a factor of domestic inflation.
Specific domestic causes of inflation certainly exist. However, this internal inflation can easily be imported to other nations via globalization. Global value chains (GVCs) exist when “different stages of the production process are located across different countries” (OECD). By virtue of a GVC, price inflation of an input produced in one country can translate to inflation in another country that imports this inflated input. For example, if prices increase for U.S. aerospace parts and the U.K. imports these inflated aerospace parts to build planes, the U.K. will also experience plane price inflation. Broadly, this trend assumes the massive effect of “importing” inflation from one country to another (Auer).
Given the globalized nature of inflation, tightening monetary policy cannot be one-dimensional. Pricelevel dynamics now respond to global forces, complicating the impact of domestic-focused monetary policy. Auer deduces that central banks must coordinate with each other to target specific causes of inflation (2017). Some factors causing inflation “are beyond the control of individual central banks” (Auer).
Effects of Uncoordinated Monetary Policies
Applying their Open-Economy Macroeconomic Model, Obstfeld and Rogoff find risk in central banks conducting monetary policy centered only on a national, but not global perspective (2002). With inflation globalized (see Figure 2) and central banks all raising interest rates without any careful communication or
coordination (see Figure 3), unintended negative consequences are in the wind. Central banks should adopt similar monetary policies, increasing interest rates to cool inflation, but they require a cautionary cooperation regime. This section identifies three effects of this absence of cooperation: a) overestimation,
b) competitive appreciation cycle, c) spillovers into developing nations.
Absent careful calibration, central banks could very well overestimate the monetary contraction needed to tame inflation. By aggressively pushing interest rates in the same direction, central banks amplify each other’s policies without accounting for the feedback loop (Obstfeld, 2022). The World Bank recently
warned that if monetary policies so sightlessly match each other, “they could be mutually compounding…and steepen the global growth slowdown” (Morris, 2022). Central banks must collaborate to assess their collective impact on global demand and lower the global recession risk. Monetary policies are misguided
without cooperation as they cannot target the root cause of inflation, especially if it is imported through global value chains (Auer). Only through communicated policy calibration can individual central banks minimize avoidable economic slowdowns.
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