Central bankers face stiff new challenges in fragmenting and fractious world

That has implications for costs and inflation. Lagarde said in her speech last week that if global value chains fragmented along geopolitical lines, the increase in consumer prices could range between five per cent, in the near term, to about one per cent, in the long run.

With the West dependent on China for many of the critical resources needed for the 21st Century economy – rare earths, batteries for electric vehicles, and solar panels – complete decoupling is impractical, but the path to diversification is likely to be messy and potentially, if the tensions between the US and China continue to rise, traumatic.

It won’t be easy for governments to steer a course between complete decoupling from China and its allies/dependents – an outcome that US Treasury Secretary Janet Yellen as said last week would be disastrous – while trying to protect their own national economic and security interests. Nor will it be costless even if they can.

That’s the new environment that central bankers are supposed to navigate despite simple mandates that generally focus on price and financial system stability and employment.

Before the pandemic, the central banks didn’t have to concern themselves with supply side issues nor, before the war in Ukraine and the increase in trade and geopolitical frictions between the US and China, did they have to spend much time thinking about the implications of efforts to reduce the dominant role the US dollar plays within the global economy.

Now they are confronted with a host of new issues to consider, many of which are beyond their control and for which monetary policy tools – interest rates and liquidity – are quite crude instruments for responding to complex challenges.

Lagarde’s prescription is for fiscal policies to complement monetary policies.

“If fiscal and structural policies focus on removing supply constraints created by the new geopolitics, such as securing supply chains or diversifying energy production, we could then see a virtuous circle of lower volatility, lower inflation higher investment and higher growth.”

“But if fiscal policy instead focuses mainly on supporting incomes to offset cost pressures in excess of temporary and targeted responses to sudden large shocks, that will tend to raise inflation, increase borrowing costs and lower investment in new supply,” she said.

That would imply more co-operation and co-ordination of policies by governments and their central banks than has been the case in the major economies in recent decades and, perhaps, a tolerance for somewhat higher inflation rates than previously targeted during the transition from the global economy that existed pre-pandemic to the new world order.

Last week the federal treasurer, Jim Chalmers, released a review of the Reserve Bank which recommended a not-so-radical restructuring of the bank with the establishment of separate boards for monetary policy and governance of the bank. The monetary policy board would be a panel of experts drawn from outside the bank.

The model isn’t radical because the Fed, Bank of England and other central banks use the same structure rather than the mix of RBA executives and non-economists drawn largely from corporate Australia that have traditionally filled the RBA board, which for decades (until the pandemic) presided over what was one of the world’s most highly regarded and best-performing central banks.

It’s worth noting that while the review was prompted largely, albeit not entirely, by the RBA’s misjudgment of the impact of the pandemic, the same mistakes the RBA is being held accountable for were made by its peers in larger economies offshore, despite their panels of economic experts.

Indeed, the Fed’s insistence that the supply chain disruptions were transitory, which delayed its response to the outbreak of inflation, not only helped lead other central banks into the same trap of complacency but almost forced them into it because, for the Reserve Bank, running a policy that diverges too far from the world’s most powerful central bank has implications for their exchange rate.

Had the RBA started raising Australia’s interest rates earlier and faster, the Australian dollar would have surged, potentially dramatically, undermining the competitiveness of exports at a delicate moment for the economy.

In any event, the review and restructure are, at their heart, non-events (unless you are an RBA employee or director).

They would not guarantee the new-look RBA would be any more or less successful than the old RBA, although distancing people with experience in the “real” economy and handing monetary policies decisions over to technocrats carries some risk if there are substantial and structural changes occurring within the economy.

Whatever the structure of the central bank, the currents running through geopolitics and economies are evolving into tides. Regardless of how they are structured and peopled, they will be confronted with new and complex uncertainties and challenges in a fragmenting, multipolar world.

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