Central banks should avoid reacting too strongly to headline inflation – IMF

The International Monetary Fund (IMF) has advised central banks to refrain from reacting too strongly to sudden changes in headline inflation, especially when those fluctuations are caused by unstable energy prices. However, central banks should act if higher inflation begins to influence expectations, wage negotiations, or if technological advancements start to enhance the impact of headline inflation on core inflation.

The IMF expressed concern that if the inflation surge following the pandemic erodes confidence in the monetary policy framework, central banks should respond more swiftly to indications of this effect caused by inflation on expectations or stronger price transmission. Failing to address a shift in inflation expectations in response to current shocks could prove costly if similar shocks emerge in the future, as it could jeopardize the credibility of monetary policy.

The IMF warned that if the negative effects of the war or emergence of financial risks eventually outweigh the situation, leading to a decline in growth, a softening of labor markets, and a subsequent drop in underlying inflationary pressures, there might be room for monetary policy to adopt a more accommodating stance. Any such easing should be gradual and data-driven, maintaining consistency with returning inflation to its target level.

Central banks worldwide are heavily focused on inflation targeting policies to tackle rising inflation, typically achieved by decreasing the money supply in circulation and raising borrowing costs. The IMF emphasized that central banks should provide a clear explanation of how new data influence the risk balance, what would necessitate a change in policy direction, and how they differentiate between short-term price changes and persistent inflationary pressures.

This approach can help prevent households, businesses, and financial markets from misinterpreting conditional policy guidance as unconditional commitments. With rising fiscal costs and heightened electoral pressures in many countries, central banks may encounter renewed calls to accommodate higher public borrowing or permit inflation to exceed the target rate.

The IMF stressed that preserving the legal and operational independence of central banks and shielding monetary policy from political influence and fiscal dominance are crucial.