Most of us live our lives within some kind of framework. Sometimes, it's a formal framework, associated with, say, an employment contract or criminal law. On other occasions, it's an informal framework, the kind of thing that might govern family life.
We use these frameworks to form expectations about the future. We know, for example, that an attempt to break into someone else's house might be met by arrest and imprisonment. We know also that alcohol or drug abuse can destroy family life. Our frameworks allow us to make rough predictions of outcomes that stem from given actions.
Central banks also live within frameworks. They use them to evaluate the effects of changes in monetary policy.
For today's central bankers, however, there's a bit of a problem. The frameworks which have proved reliable in the past appear to be breaking down. One standard approach used by central banks is to consider changes in interest rates against measures of the amount of spare capacity within an economy. The idea is simple. Each economy has a "supply potential", the point at which resources are used to such a degree that there is a tendency neither for inflation nor deflation. If interest rates can be moved to set demand at a level consistent with "supply potential", it follows that the central bank will, through time, achieve price stability.
Another approach is to think about inflation from the angle of money supply growth. Given that inflation is, in some sense, a monetary phenomenon, a central bank could take the view that accelerating money supply growth might say something about future inflation, even if there is little immediate evidence of inflationary pressures coming from, say, measures of spare capacity. At the moment, neither of these approaches is working particularly well. The problem with the first lies with the inability of central banks to be sure about the size of supply potential. The Bank of England, for example, has to fret about the scale of labour immigration. It knows the scale of recent immigration has been big, but, beyond that, information is really rather sketchy.
Perhaps the best that can be said is that labour supply has probably increased, that supply could increase further if the UK's borders aren't shut and that additional supply may have a restraining effect on wage increases. This, though, is all rather vague. In turn, estimates of the amount of spare capacity are not likely to be terribly reliable.
Meanwhile, money supply is also distorted. With capital flowing across borders at ever-faster rates, and bank deposits switching from one jurisdiction to the next, it's increasingly difficult to work out what, if anything, accelerating money supply growth means.
Why are these frameworks looking so creaky? The answer lies with globalisation. Central bankers are central to their countries or economic regions. Yet increasingly our national economic destinies are being affected by developments all over the world. As cross- border trade and capital flows have increased, so has our interdependency with other nations. In this context, a monetary framework that relies on the measurement of domestic spare capacity or money supply looks increasingly anachronistic.
To see why, imagine a world with a single central bank and a single currency. …