The Central Bank's Awkward Quarter
An economy has an inflation rate of 6% (target 2%), unemployment of 4.5% (estimated natural rate 5%), and GDP growth of 1.2% (potential 2.5%). The central bank's policy rate is 3.0% and the neutral rate is estimated at 2.0%. A supply shock from energy prices has raised costs across the economy. The government has just announced a large unfunded spending package. Bank reserves are ample, and the central bank pays interest on reserves at the policy rate. One board member argues for an immediate 150-basis-point hike; another says the economy is below potential, so the bank should cut.
1. Diagnose the policy problem using the inflation, unemployment, and output gaps, and recommend a policy-rate path with reasoning.
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The economy is in a stagflationary position: inflation is 4 points above target, but unemployment (4.5%) is below the 5% natural rate and growth (1.2%) is below potential (2.5%). These signals conflict. Below-natural unemployment suggests a tight labor market and demand pressure; sub-potential growth suggests slack. The supply shock explains part of the inflation - it raises costs and can also depress output, so the bank faces a trade-off rather than a simple case.
The real policy rate is 3.0% − 6% = −3.0%, far below the neutral real rate of about 0% (2% nominal neutral minus 2% target). Policy is highly accommodative. A 150bp hike would bring the nominal rate to 4.5% and the real rate to about −1.5% - still accommodative. A cut would deepen negative real rates and risk unanchoring expectations.
Recommendation: hike, but in steps and communicate a path, not a single 150bp shock. Raise 50bp now, signal further moves contingent on inflation expectations, and explicitly 'look through' the supply shock only to the extent it does not feed into expectations. The unfunded spending package adds demand pressure, reinforcing the case against cutting. The below-potential growth is a reason for gradualism, not for easing.
2. Explain how interest on reserves and ample reserves change the transmission of the policy rate, and how the bank should sequence its tools.
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In an ample-reserves regime, the central bank does not manage the quantity of reserves to move the rate; it sets an administered rate. Paying interest on reserves (IOR) at the policy rate puts a floor under short-term market rates, because banks will not lend below what they can earn risk-free at the central bank. The overnight reverse repo facility reinforces the floor for non-banks. So the policy rate is transmitted by administered rates, not by open-market operations changing reserve supply.
Sequencing: (1) raise IOR and the policy rate together to move the floor; (2) use the reverse repo rate to keep the effective rate inside the corridor; (3) communicate the path to shape expectations, since expectations are a major channel; (4) only use balance-sheet tools (asset sales) as a secondary instrument, because they are slower and less precise. A good answer notes that the 150bp hike's effect depends on pass-through to lending and deposit rates, which is faster in an ample-reserves system than the textbook money-multiplier story suggests. The board member who wants a cut misunderstands the real rate: with inflation at 6%, a 3% nominal rate is already loose, so cutting would be procyclical.