Systems and Signals...

Trade cycles – booms and busts - have been imminent while adjusting money supply, interest rate and prices or inflation and unemployment in the economy through the monetary policy, in short, if we say that the monetary policy also gives birth to the trade cycles, apart from the market mechanism which also helps clear excess demand and supply or exuberance through price adjustments as in the stock market, would not be far from reality. 

Using it the central bank controls investment unemployment and prices in the economy to keep the value of money and demand intact, but as the time rolls we have seen the value of money going down due to rising prices and interest rate, cost of investment going up which might also restrict the ability to employ and increase supply. 

The central bank during inflation increases interest rate to reduce demand and prices, but this also reduces investment employment and  supply and growth, which further increases prices and could be misleading while attempting to contain demand which also reduces supply and growth, when it might lower cost of investment to increase supply, imports too. 

During higher inflation and wage cost, higher cost of capital could further drag down supply which would accentuate the problem of inflation and loss in the value to money. 

Moreover, higher prices (and lower borrowing cost) could increase supply and lower the price level, but by intervening through higher interest cost the central bank restricts the supply or market mechanism to work to lower the price level, which would increase demand and prices in the future giving rise to trade cycles, swing between high demand and high supply or between higher prices and lower prices. 

Nonetheless, the job of the central bank is not to control all the price movements, but to control excess volatility beyond the targets in a time frame, a stock market has limits for price on a daily basis which moves up and down depending on demand and supply and sometimes unexpectedly. 

Expecting prices movements is a bit tardy and difficult for the central bank too as we can see the inflation target set by the Fed has been consistently undershot years despite ultra accommodative conditions. 

Notwithstanding, the Fed has let the stock market prices to go unregulated and market dependent, but has set a limit for inflation in the economy which has reduced price adjustments based on the demand and supply in the economy, a two percent inflation target or profit or price limit could be too low for to incentivize demand and supply and investment and employment and growth to reach the potential.

It would give rise to frequent and small trade cycles requiring frequent adjustments in money supply and interest rate meaning more and frequent intervention by the monetary policy.

The inflation targeting has cut down the length of the expansion of the trade cycles and increased worry about an inverted yield curve, when short run interest rate exceed long run rate which has always been followed by recession. 

Nonetheless, a clear and loud signal about the neutral real interest rate and price or inflation limits – upper limit or lower limit - could help manage spending and demand and supply and growth by managing interest rate and expectations.

Prices near the lower target would mean lower interest rate and expectations and spending and near high would signal higher interest rate and expectations and lower spending or increase deleveraging.

Lack of proper communication or knowledge about its actions on the part of the central is the main reason for bad outcomes and uncertainty or exuberance in the economy or the stock market, people know not much how the system works and signals of monetary policy, stock market too……