When a central bank is able to engineer soft economic landings, that is monetary policymaking at its best.
A renowned economist with a philosophical bent once said that mankind’s three greatest discoveries were fire, the wheel and central banking.
Placing central banking alongside fire and the wheel among mankind’s greatest discoveries is not a mistake, for it is a very powerful tool for the delivery of progress and the maintenance of socio-economic stability in a society. Socio-economic stability – and, ultimately, political stability – would be well-nigh impossible to maintain in a society without a monetary system built around a central bank.
What makes a central bank an indispensable part of a society? There are four reasons.
First and foremost, there has to be an institution with the sole authority to issue currency. Obviously, there cannot be more than one currency-issuing institution; that is a formula for chaos and disorder. By virtue of its statutory status as an independent entity, a central bank alone decides how much money – the total of notes and coins –will be circulating in an economy at any one time. That total will depend on the judgment of the Monetary Board – the policymaking body of the Bangko Sentral ng Pilipinas (BSP), as to the non-inflationary currency requirement of the economy.
The second reason why central banking is an indispensable part of a society is that the nation’s banking system – banks and non-bank financial intermediaries (NBFIs) – has to be regulated. A nation’s banking system can make its maximum contribution to the development of each economy only if the central bank does an efficient job of regulating the nation’s financial institutions.
The third reason why central banking is an indispensable part of a society is that a stable financial system requires an efficient last-resort lending mechanism. A central bank – the BSP in our case – is the leader of last resort, making last-resort loans to the banks and NBFIs it supervises.
The fourth, but definitely not the least, reason is that there must be an institution that sets the benchmarks for the interest rates that banks and NBFIs charge for loans, placements, deposits and other financial transactions.
A central bank’s power to determine the economically appropriate money-supply level, combined with its power to influence interest rates, makes it a very powerful institution. The levels at which the Monetary Board sets the BSP’s interest rates influence the citizenry’s decisions to borrow, to spend, to save and to invest; the aggregates of those decisions, in turn, determine the money supply.
Every student of economics is taught that the single most important function of a central bank is to maintain price stability, i.e., prevent inflation or deflation. Inflation occurs when – stated in the simplest terms – too much money is chasing too few goods; loss of purchasing power is the outcome of inflation. The opposite is true of a deflationary situation.
There has been a long-running debate between economists and non-economists as to whether economics is a science or an art. The debate is particularly fierce when the subject is monetary policy. Whether the economics of monetary policymaking is a science or an art largely depends on whether elements such as intuition, anticipation, hunch-playing and studied guesswork are considered legitimate elements in the making of monetary policy.
Like most human activities, monetary policymaking can be either reactive or pro-active. When it is of the reactive kind, monetary policymaking merely acts in a manner confirmatory of the evidence established by the other economic agencies of the government. Thus, having seen the price, production and employment data gathered by the Philippine Statistics Authority (PSA) and the Department of Trade and Industry (DTI), the BSP has embarked on an expansionary approach to interest-rate setting. BSP interest rate policy can hardly remain in a restrictive mode when the signs point to economic recovery in a declining-inflation setting.
The title of this column speaks of a central bank performing at its best. That happens when a central bank “leans against the prevailing economic winds” – to quote a distinguished postwar chairman of the U.S. Federal Reserve Board – and makes interest rate and other policy decisions before the economic cycle reaches its peak or its trough.
When a central bank is able to engineer soft economic landings, that is monetary policymaking at its best.
