Is inflation the only answer to central bank questions?

Investing.com — The role of central banks in managing economies has grown increasingly complex, especially in the post-COVID-19 era, where inflation has surged to levels not seen in decades. 

Traditionally, inflation control has been the primary objective for most central banks, but in today’s economic environment, is inflation the only answer to the questions central banks face? 

Central banks operate in a data-dependent manner, basing their decisions on a wide array of economic indicators. As per analysts at Morgan Stanley, inflation, while critical, is not the only factor shaping central banks’ policy choices. 

“As inflation decelerates from its post-covid highs, the set of data that determine monetary policy paths are large,” the analysts said.

In recent months, inflation has begun to slow, but the data remains noisy. For example, Morgan Stanley says that inflation figures are still volatile, making it difficult for central banks like the European Central Bank (ECB) and the Bank of England (BoE) to commit firmly to rate cuts or hikes​. 

The inconclusive nature of recent U.S. payroll data has only added to this uncertainty, further emphasizing that inflation control alone cannot address all the concerns facing central bankers.

Central banks must balance inflation control with other macroeconomic considerations, including economic growth and exchange rate stability. 

As per Morgan Stanley, U.S. consumer spending remains robust, supporting GDP growth even as inflation moderates. However, the strong dollar, driven by a relative shift in central bank policies between the U.S. Federal Reserve and other economies like the Eurozone, poses new challenges. 

A stronger dollar has bolstered the euro and yen, adding to the complexity of the inflation-growth equation

For example, the ECB’s decision to cut rates in June 2024 was expected, as slow economic growth and soft wage increases seemed to signal that inflation was cooling. 

However, as Morgan Stanley points out, balancing inflation with growth concerns has left a “murky path forward” for the ECB, which now faces pressure to stimulate growth without reigniting inflation​.

Another critical factor for central banks, flagged by Morgan Stanley, is the role of foreign exchange (FX) rates in shaping inflationary pressures. In August 2024, the euro strengthened against the dollar due to divergent central bank expectations, which helped contain inflation temporarily. 

However, a sharp appreciation of the dollar could undo some of these gains by driving up the cost of imports, thereby contributing to imported inflation in the missing regions like Europe​.

“Back in Japan, where much of the crossmarket adjustments started, the inflation data have cooled temporarily. The market has been particularly attuned to the Governor and Deputy Governor’s balancing act in communicating the implications of the inflation volatility,” the analysts said.

The BoJ’s choice to keep rates unchanged, while navigating the balance between rising wages and inflation, underscores the complex relationship between managing inflation and broader economic factors, as per Morgan Stanley.

Inflation may be the headline economic issue, but labor markets and wage growth are equally critical for central banks in shaping monetary policy. 

Morgan Stanley mentions that wage dynamics in the Eurozone and the U.S. will play a key role in determining inflationary outcomes in the near future. 

Softer wage growth, as seen in the Eurozone, points to potential easing inflationary pressures. 

However, this also raises concerns about consumer spending and growth, which are equally important factors for central banks.