Central bank’s job

The more I study the job of a central bank, the more thought I have. In most central bank nowadays, the main responsibility of the central bank is to maintain price stability. The policy is inflation targeting. There are many different form of inflation targeting. From a strict targeting like UK and New Zealand, to a more flexible inflation targeting like Mexico and Brazil. The whole point for this policy is to make sure that inflation is in the target range.

Investors often project the central bank’s policy stance, by looking at the latest inflation/cpi number. When it is above the market expectation or when it is close to the upper bound, the market expects a rate hike and vice versa. This sounds to me a very wrong interpretation.

Here is why: we all know that from interest rate hike to money supply to investment to domestic demand takes time. Or from interest rate hike to credit contraction to less money in the market to less liquidity takes time. We also know that the latest inflation/CPI number is mostly a month old. So, from the inflation number released to the interest rate hike, and from the interest rate hike to the real effect on inflation will probably take more than 2 months, not to mention that a lot of economies do not have a smooth monetary transmission. So, this time lag will basically make the monetary policy ineffective.

So, what is the point to have a monetary policy? Because of this time lag, the only propose of the monetary policy is to stabilize inflation expectation. Nowadays, inflation survey has been released in many of the countries. The expectation is mostly available a few weeks before the realized figure. Does that make sense for the central bank to put more weigh on the deviation between inflation expectation and the inflation target, rather than the deviation between realized headline inflation and the inflation target.

So, what is the point on that? We are having inflation hyper in Mexico these days. Latest bi-weekly Inflation is downtrend, same as the core cpi. Inflation expectation in 2007 and 2008 (also implied by the wage negotiation settlement) are not out of line from the central bank. So, why need hike rate? May it better for the bank to talk more aggressively to stabilize inflation expectation and act only when the expectation is against the bank’s view? I would guess this is what the bank did this morning. It states:

“the Board will remain attentive that core inflation is complying with its own forecasted trajectory (both monthly and annual) consistent with a decline by March. If not, the Board will tighten monetary policy."