Is inflation the only answer to central bank questions? Via Investing.com

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

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

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

“As inflation eases from its post-covid highs, the data set driving monetary policy paths is large,” analysts said.

In recent months, inflation has started to fall, but the data remains noisy. For example, Morgan Stanley says inflation numbers are still volatile, making it difficult for central banks such as the European Central Bank (ECB) and the Bank of England (BoE) to firmly commit to cutting or raising rates.

The inconclusive nature of recent US wages data has only added to this uncertainty, further underscoring that inflation control alone cannot address all of the concerns facing central bankers.

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

According to Morgan Stanley, US 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 US Federal Reserve and other economies such as the eurozone, poses new challenges.

A stronger dollar supported 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 sluggish economic growth and weak wage increases seemed to signal that inflation was cooling.

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

Another critical factor for central banks, highlighted 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 to temporarily contain inflation.

However, a sudden appreciation of the dollar could wipe out some of these gains by increasing the cost of imports, thereby contributing to imported inflation in deprived regions such as Europe.

“In Japan, where many of the market adjustments have started, inflation data has cooled temporarily. The market was particularly attuned to the governor’s and lieutenant governor’s balancing act in communicating the implications of inflation volatility,” analysts said.

The BoJ’s choice to keep rates unchanged while navigating the balance between wage growth and inflation underscores the complex relationship between inflation management and broader economic factors, according to Morgan Stanley.

Inflation may be the main economic issue, but labor markets and wage growth are just as central to central banks in shaping monetary policy.

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

Weaker wage growth, as seen in the euro area, points to a potential easing of inflationary pressures.

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