Understanding the role of central banks

Recently, the 2026 Nobel Prize in economics was awarded to Robert Hall of Stanford University and Michael Woodford of Columbia University. My column last Sunday was supposed to be an explanation of why these two economists received the award. Unfortunately, because of lack of space, I was able to focus only on Robert Hall.

This column today will therefore focus on the work of the other awardee, Michael Woodford. His research is important because he helped explain why the effectiveness of monetary policy depends not only on the interest rate a central bank sets today but also on what households, businesses and financial markets expect to do in the future. His research helped establish the importance of expectations, transparencies and credibility in modern central banking.

His 2003 book “Interest and Prices: Foundation of a Theory of Monetary Policy” has become an influential foundation for research and policy making at central banks worldwide. One of his most important insights is that monetary policy influences the economy through expectations about future economic conditions. When households decide whether to buy a house or when businesses consider expanding their operations and when banks determine lending rates, they consider not only current interest rates but also what they believe will happen in the future.

Central banks around the world, including the Bangko Sentral ng Pilipinas or BSP, follow several principles associated with Woodford’s research. The normal primary monetary policy objective of a central bank is to maintain low and stable inflation which will hopefully lead to balanced and sustainable economic growth. There are several lessons that Woodford’s research can offer central banks.

First, central banks can continue improving how it explains interest rate decisions. When inflation rises, which is what is happening in the Philippines today, the public needs to understand whether the increase is caused by strong domestic demand, food shortages, higher international oil prices, exchange rate movements or other factors.

The concerned central bank should explain how these developments affect its assessment of inflation and why they may lead to a particular policy decision.

Second, the central bank can strengthen forward-looking communication instead of discussing only the latest inflation rate or the latest interest rate adjustment. It can explain the economic conditions that could justify future changes. For example, it can describe how persistent inflationary pressure, weakening domestic demand or changing inflation expectations would affect its assessment. This gives households and businesses a clearer understanding of the central bank’s framework for its interest rate decisions.

Third, the central bank can place greater emphasis on credibility. Woodford’s research suggests that public expectations are influenced by whether a central bank’s action is consistent with its stated objectives. If the central bank communicates an inflation target, the public needs to understand how it intends to respond when inflation moves away from that target and what circumstances may limit its ability to control inflation.

Fourth, the central bank must learn how to communicate not just with the business and political sectors but also with ordinary Filipinos. Monetary policy can seem complicated because terms such as inflation targeting, policy rates and forward guidance are unfamiliar to most people. Explaining these concepts in everyday language can help households understand how policy decisions affect loans, savings, prices and purchasing power.

Fifth, the central bank should recognize the limits of monetary policy. If rice prices rise because of inadequate supply, higher interest rates cannot produce more rice. If transport costs rise because of rise in fuel prices, monetary policy cannot directly eliminate those costs. The central bank can manage the broader inflationary consequences but it is the agricultural, energy and infrastructure agencies that must address the problem of supply.

There has been a lot of discussion whether economic theory has any practical value. In 2014, Woodford said in an interview: “Central banking is one of the human activities where I think there is some real use to relatively abstract theoretical contributions.” He is explaining why theoretical economics can have practical value. Models of expectations, inflation and interest rates can help policy makers analyze how their decisions may affect the real economy.

The central bank can use economic models and empirical evidence to assess possible outcomes of their monetary policies. These methods can also be used in analyzing Philippine conditions including food price volatility, external shocks like increase in oil prices and differences in household access to credit.

Other economists have considered Woodford’s book as the bible for central banks. Others have also described Woodford’s theoretical framework as having become a major foundation for research and policy making at central banks worldwide.

While the research of Robert Hall explains how households consider their expected long-term income when deciding how much to spend or save, Woodford’s work explains why monetary policy is influenced by expectations, interest rates, credibility and communication.

The lesson to be learned is that sound economic policy depends not only on what a central bank does today but also on how people understand its decisions and how those decisions shape expectations about tomorrow.