Stephen King: Globalisation has left central banks facing a world of growing economic uncertainties

Most of us live our lives within some kind of framework. Sometimes, it's a formal framework, associated with, say, an employment contract or criminal law. On other occasions, it's an informal framework, the kind of thing that might govern family life.

We use these frameworks to form expectations about the future. We know, for example, that an attempt to break into someone else's house might be met by arrest and imprisonment. We know also that alcohol or drug abuse can destroy family life. Our frameworks allow us to make rough predictions of outcomes that stem from given actions.

Central banks also live within frameworks. They use them to evaluate the effects of changes in monetary policy.

For today's central bankers, however, there's a bit of a problem. The frameworks which have proved reliable in the past appear to be breaking down. One standard approach used by central banks is to consider changes in interest rates against measures of the amount of spare capacity within an economy. The idea is simple. Each economy has a "supply potential", the point at which resources are used to such a degree that there is a tendency neither for inflation nor deflation. If interest rates can be moved to set demand at a level consistent with "supply potential", it follows that the central bank will, through time, achieve price stability.

Another approach is to think about inflationfrom the angle of money supply growth. Given that inflation is, in some sense, a monetary phenomenon, a central bank could take the view that accelerating money supply growth might say something about future inflation, even if there is little immediate evidence of inflationary pressures coming from, say, measures of spare capacity.

At the moment, neither of these approaches is working particularly well. The problem with the first lies with the inability of central banks to be sure about the size of supply potential. The Bank of England, for example, has to fret about the scale of labour immigration. It knows the scale of recent immigration has been big, but, beyond that, information is really rather sketchy.

Perhaps the best that can be said is that labour supply has probably increased, that supply could increase further if the UK's borders aren't shut and that additional supply may have a restraining effect on wage increases. This, though, is all rather vague. In turn, estimates of the amount of spare capacity are not likely to be terribly reliable.

Meanwhile, money supply is also distorted. With capital flowing across borders at ever-faster rates, and bank deposits switching from one jurisdiction to the next, it's increasingly difficult to work out what, if anything, accelerating money supply growth means.

Why are these frameworks looking so creaky? The answer lies with globalisation. Central bankers are central to their countries or economic regions. Yet increasingly our national economic destinies are being affected by developments all over the world. As cross-border trade and capital flows have increased, so has our interdependency with other nations. In this context, a monetary framework that relies on the measurement of domestic spare capacity or money supply looks increasingly anachronistic.

To see why, imagine a world with a single central bank and a single currency. Many of the problems facing today's central banks would simply disappear. There would be no exchange rates. There would be no concerns about imported price inflation, because there would be no imports. There would be less difficulty in interpreting money supply developments because there would be no cross-border capital flows and no central bank foreign exchange reserves. Global demand and supply would be more accurately measured because there would be none of the tricky aggregation issues caused by having to add estimates of national income together in the absence of a common currency.

The idea of a global central bank helps to tease out the difficulties our real-life central banks are facing. Globalisation cuts both ways. Enhanced capital and labour mobility and heightened information flows tend to penalise those economic regimes that underperform global "best practice". As a result, more and more nations have made their central banks independent and given them the common goal of price stability. If all central banks are pulling in the same direction, the chances are that each central bank, individually, will achieve price stability.

Simultaneously, though, growing economic interdependence reduces the ability of central banks, individually, to determine a nation's economic fate. There are two problems. First, there are data limitations. If, for example, UK export performance depends increasingly on the strength of activity within emerging markets, it's likely that UK export performance will become increasingly unpredictable, because emerging market economic data is often neither timely nor particularly reliable.

Second, there are co-ordination limitations. In a world of economic interdependency, it is all too easy for policymakers to disagree on the root cause of economic problems and, hence, on the appropriate solutions.

Meanwhile, for financial markets and for the man in the street, central banks' actions may appear increasingly unpredictable (the charts show how market expectations of US and UK interest rates have changed rather a lot over the past 12 months, despite not many actual changes). Academic economists seem split down the middle when it comes to dealing with economic uncertainty, whether as a result of globalisation or other disturbances. Some argue that central banks should do as little as possible; others that central banks should do a lot more.

Even here, though, there is no definitive "right" approach. In a two country - and, hence, two central bank - world, the central bank that decides to be "activist" will have an influence on the exchange rate which might, in turn, force the other central bank to become activist too, even if its staff would prefer to be "passive".

Central banks like to pride themselves on their transparency. Many have argued that with transparency comes an increased degree of predictability. I'm not sure this is right. At the moment, enhanced transparency is revealing the uncertainties, rather than the convictions, of the central banking community. There's a good chance that those uncertainties will only increase as our economic interdependence grows ever more complex.