Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Set Policy Amid Global Uncertainty
Transcript
- Lucas: So it's mid-June 2026, and we've got a pretty interesting puzzle on our hands. Central banks around the world are staring at an economic outlook that looks more like a Rorschach test than a clean forecast. Luna: Yeah, it feels like every data release gets a different read. One week inflation is sticky, the next it's softening. Lucas: Right. And the question is — how do central banks actually set policy when the fog is this thick? We've talked a lot about specific tools, but the broader decision-making frame when uncertainty is high — that's worth a deep dive. Luna: Let's start with a concrete case. The Bank of Japan just held its policy rate at 0.5 percent at the May meeting. That was widely expected, but what caught my eye was their statement. Lucas: Yeah, the language was notably cautious. They cited 'extremely high uncertainties' around trade policy and commodity prices. And crucially, in their April Outlook Report, they published something they've never done before — three alternative scenarios for inflation, each with a different path for core CPI. Luna: Three scenarios. So that's a signal in itself — they're saying, 'We don't know which world we're in'. Lucas: Exactly. And that's a shift from the traditional central bank playbook, which tends to present a single baseline forecast and maybe a fan chart around it. Publishing discrete scenarios is a more honest reflection of the uncertainty. The BOJ's scenarios ranged from inflation staying above 2 percent through 2027 to a sharp decline below 1 percent if global demand weakens. Luna: That's a wide spread. And it's not just Japan. The Fed is doing something similar with their 'dot plot' — but the dots have been diverging more at recent meetings. Lucas: Right. At the March 2026 FOMC meeting, the median dot still pointed to two cuts this year, but the dispersion was the widest since 2022. You had some members seeing no cuts at all, and others projecting three or four. That kind of disagreement inside the committee tells you the outlook is genuinely contested. Luna: And the ECB — they've been hiking into this uncertainty, albeit slowly. They raised rates by 25 basis points in April, bringing the deposit rate to 3.75 percent. But Lagarde's press conference was full of caveats. Lucas: Yeah, she leaned heavily on the phrase 'data-dependent and meeting-by-meeting'. Which is central bank speak for 'we're not pre-committing to anything because we don't know what the data will look like.' But here's the thing — there's a whole literature in monetary economics about how to set policy under uncertainty. One key concept is the 'risk management' approach. Luna: Risk management — as opposed to the standard Taylor rule type of response. Lucas: Right. The classic Taylor rule says: set the rate based on current inflation and the output gap. But when uncertainty is high — say, around the natural rate of unemployment or the persistence of supply shocks — that mechanical approach can lead you astray. Risk management says: consider the distribution of outcomes, not just the central tendency, and adjust policy to insure against the worst tail risks. Luna: So in practice, that might mean keeping rates higher for longer even if inflation looks like it's coming down, because the cost of being wrong on the high side is lower than the cost of easing too early. Lucas: That's exactly the logic the Fed has been using. Chair Powell has said explicitly that the cost of overcooling the economy is less than the cost of letting inflation re-anchor above target. So they are deliberately running a slightly tighter policy than the midpoint of uncertainty estimates would suggest. It's an insurance premium. Luna: But that insurance isn't free. If they overtighten, they could tip the economy into recession. Lucas: No, it's not free at all. And that's the debate. Some economists argue that the costs of a recession are higher than a moderate inflation overshoot. But central banks have asymmetric preferences — they hate high inflation more than they hate a mild recession. That's been the dominant view since the Volcker era. Luna: So how does a central bank decide which tail risk to insure against? Is it purely based on the data, or is there a subjective element? Lucas: There's definitely a subjective element. The data can tell you the probabilities, but the choice of which risks to prioritize is a judgment call. And that judgment is shaped by the institutional culture, the history, and even the personalities on the committee. Take the Bank of Japan — they have a long history of deflation, so they are naturally more inclined to worry about undershooting inflation than overshooting. That's why they're holding rates low despite CPI being above 2 percent for over a year. Luna: So the BOJ's scenario analysis is almost like a public insurance policy — they're telling markets, 'We see the risks, and we're prepared to act differently depending on which scenario unfolds.' Lucas: Exactly. And that's where communication becomes a policy tool in itself. By publishing the scenarios, they're shaping expectations. Markets can price in different paths, and that feeds back into financial conditions. If the market believes the BOJ will act aggressively if deflation risks resurface, long-term inflation expectations stay anchored. That's the theory, anyway. Luna: And what about the role of fiscal policy? Because uncertainty isn't just about inflation — it's also about what governments are going to do. The US fiscal deficit is running at 6 percent of GDP, and the next election is in November. That adds another layer. Lucas: Huge layer. Central banks have to make assumptions about fiscal policy, but those assumptions are themselves uncertain. If the next administration enacts large tax cuts or spending increases, that could be inflationary. If they pursue austerity, it could be disinflationary. The Fed has to essentially guess, and that guess feeds into their rate decisions. Luna: So we've got a fog of war — trade policy, commodity prices, fiscal paths, structural shifts in the labor market. No wonder central banks are hedging. Lucas: And one more layer: the neutral rate of interest, r-star, is itself highly uncertain. Estimates range from 0.5 percent to 2 percent in real terms. So the Fed doesn't even know exactly how restrictive current policy is. That ambiguity alone argues for a cautious, gradual approach. Luna: It's like driving in heavy fog — you slow down, you keep your lights on, and you're ready to brake at any moment. Lucas: That's the perfect analogy. And the central banks that are doing this well are the ones that communicate that posture clearly. The BOJ's scenario analysis, the Fed's emphasis on risk management, the ECB's meeting-by-meeting language — all of it is about managing expectations in a fog. Luna: You know, talking about uncertainty in economics reminds me of why we love doing this show. If walking through the economy with us has made something click, there's a way to keep it going — listener support is what keeps us ad-free and independent. Lucas: Yeah, it's a small thing that makes a big difference. If you've gotten value from our deep dives into monetary policy, you can throw a few dollars into the tip jar at buy me a coffee dot com slash fexingo. All lowercase. Luna: Exactly. No pressure, but it helps us keep the lights on and the episodes coming. Lucas: So back to the fog — one thing that's clear is that central banks have become much more transparent about their uncertainty. Twenty years ago, a central bank would never have published alternative scenarios. Now it's becoming standard practice. That's a net positive for markets and for the public. Luna: Agreed. So as we head into the summer, what are you watching most closely? Lucas: I'm watching the trade policy developments — tariff decisions from the US and the EU's response — because those have the power to shift the inflation trajectory quickly. And then the July BOJ meeting, to see if they update their scenarios. That will tell us how their thinking is evolving. Luna: And I'll be watching the Fed's June statement — any change in the risk assessment language could signal a shift in the insurance premium. Lucas: Exactly. Central banks are navigating by the stars, but the stars are moving. The fog may not lift for a while, but at least we know they're using better maps than they used to.