The Limits of Central Bank Capability

The ability of a central bank to maintain the stability of a currency’s value is determined by three factors: inaccurate economic models, fiscal constraints, and structural economic constraints. Through various combinations of monetary policy, a central bank can maintain currency stability and, to a certain extent, stimulate economic growth.

First, the constraint of inaccurate economic models. The domestic purchasing power of the Rupiah is measured by inflation, while its international purchasing power is measured by the exchange rate. When inflation is already very low, raising interest rates to defend the exchange rate will be ineffective. Raising interest rates when inflation is low can even reduce liquidity in society, increase the potential for bad loans, decrease production, and increase unemployment, thereby reducing purchasing power and potentially shifting the Phillips curve to the right. This leads to stunted growth and rising inflation.

Researchers from the National Bureau of Economic Research (NBER), Levin and Sinha, explain in their study, “Limitations on the Effectiveness of Monetary Policy Forward Guidance in the Context of the Covid-19 Pandemic,” that inaccurate economic models can result in erroneous monetary policies, such as unexpected shifts in the Phillips curve. Similarly, NBER researchers Bergman, Born, Matsa, and Weber explain that hawkish monetary policies (high interest rates) will pressure the labour market and potentially increase unemployment.

When inflation is low and stable, it indicates that the Rupiah’s purchasing power is strong and stable domestically. If, at the same time, the Rupiah weakens and experiences sustained volatility, the cause may be foreign exchange market ‘noise’. This noise is created through covert market manipulation involving unusual market activity, typically through the capital market. Large players sell shares and convert the proceeds into foreign currency, causing both the Jakarta Composite Index (IHSG) and the Rupiah to weaken simultaneously. This noise is exacerbated by the ‘herding effect’, where smaller players mimic the actions of large players. In such scenarios, raising interest rates is ineffective, and monetary interventions involving the sale of foreign exchange reserves only create a ‘tit-for-tat’ game between large players and the central bank, ultimately depleting reserves while the exchange rate continues to weaken.

Second, fiscal constraints. NBER researcher Cochrane, in the study “Monetary-Fiscal Interactions,” explains that raising interest rates will increase the interest costs of government debt. Coordination between an independent central bank and fiscal authorities is key to success. With good coordination, monetary policy can enhance the economic capacity of fiscal policy. NBER researchers Elenev, Landvoert, Shultz, and Nieuweburgh explain that monetary expansion, collaborative frameworks, and fiscal stimulus can lower the debt-to-GDP ratio and reduce fiscal risk.

Conversely, without proper coordination, central banks risk becoming insolvent or losing their independence if they are forced to finance surges in fiscal needs, or if the central bank becomes too dependent on public sector borrowing through monetary contraction. For instance, if fiscal authorities implement a stimulus to increase liquidity, but the central bank immediately withdraws that liquidity through monetary contraction, the fiscal costs increase, monetary operating costs rise, and the positive impact of the fiscal stimulus evaporates.

Third, structural economic constraints. Barghini, in the article “Central Bankers: Have They Reached the Limits of Their Power?”, explains that a central bank’s ability to stimulate growth is very limited, as long-term growth can only be achieved through fiscal policy. NBER researchers Kaplan and Miyahara explain that appropriate policies and good coordination can even improve the welfare of lower economic groups while reducing the welfare of upper economic groups. This shift in welfare between economic groups must be managed carefully to avoid social friction. NBER researchers Aguiar, Amador, and Arellano explain that shifts in budget allocation should improve the welfare of all economic groups. As Imam Ali bin Abi Thalib RA warned: “Let not the welfare of one among you increase by reducing the welfare of another.”