Since 2019, central banks have presided over perhaps the largest monetary stimulus the world has ever seen. Despite this, the surge in inflation surprised them.

They did not forecast current inflation. When it started emerging, they said it was temporary.

Now they have their backs to the wall. To reduce inflation, they must raise interest rates, a lot. But doing so will increase unemployment, losses on asset prices and bankruptcies.

What will they do? What should they do?

Central banks are the only entities that can preserve the purchasing power of our money. That is a core central bank responsibility. We rely on them to do so. They make that task much harder when they lose credibility for their commitment to that goal.

When they lose credibility, people start doubting that they mean what they say. Central banks might say that they are committed to price stability, but people may doubt their willingness to accept rising unemployment.

The more widespread such doubts, the tougher central banks must be to convince people that they mean what they say. Being tougher means a more painful path back to price stability.

How has it come to this? A paper released this week by The New Zealand Initiative, a Wellington-based think tank, addresses that question. Graeme Wheeler and I co-authored it.

Graeme Wheeler is a former Reserve Bank of New Zealand governor. Before then he was variously Treasurer, Vice President and Managing Director of Operations in the World Bank. He understands the problems that central banks face.

We both want to see central banks restore their credibility for achieving and sustaining low inflation. To do that they have to examine and acknowledge what they got wrong. They have to convince the public that they are fully committed to price stability and will not repeat recent mistakes.

The paper identifies no less than six mistakes amongst central banks since 2019.

First, central banks were too confident about their credibility for preserving low inflation. Flooding domestic and global banking systems with cash at zero (or negative) interest rates was bound to raise doubts. The more people borrowed to bid asset prices up even higher, the greater the pain it would inflict to reverse the policy.

Second, central banks put too much faith in models that assumed that the public’s inflation expectations were anchored. Models are useful for clarifying thinking. But they abstract from a much more complex reality. They can be unreliable guides to decision-making.

Third, central banks were too confident that output and employment would respond in a predictable way to cheap money. This is not so. How people react depends on how anxious they are and how they read the situation.

Optimistic people might use it to bid up asset prices. Some borrow excessively to do so, confident that central banks ‘have their back’. Central banks hope instead that they might spend it on newly produced goods and services. Anxious people may hoard money instead. The perceived context of the loose money is both very important and hard to model.

Fourth, central banks were flexing their muscles on non-core issues. Examples include climate change, economic inequality, and in some cases, indigenous people issues. They lack both expertise in these issues and effective tools for addressing them.

Fifth, government-imposed conflicting objectives undermine their commitment to price stability. For example, of full employment is also a prime goal, what is a central bank to do when inflation is high and employment growth is negative? If it does not know, how can investors, workers and employers know?

The last of the paper’s reasons for how things have come to this is the role of political pressures on central banks. Incumbent politicians do not want a recession close to the next general election. Nor do they want to see interest payments on the public debt taking 20% or more of annual tax revenues.

Governments have power over the central bank. They can influence or dictate key appointments. They can end or weaken its operating independence. It is difficult to say what role such pressures have had in producing the current debacle. But it would be naïve to rule them out.

What is the immediate outlook for inflation and economic growth around the world? The days of ultra-cheap money and ultra-high liquidity are over. The problem of excessive debt will take its toll. No disinflationary process is pleasant.

The pain ahead will be unevenly distributed. Hardest hit will be the poorer countries who have borrowed heavily in US dollars. In all countries, those with least means will likely struggle most. Those who borrowed heavily at low fixed rates and bought assets well before prices peaked should do well.

Central banks can reduce the pain by taking effective measures to restore confidence in their determination to achieve price stability. Frank diagnosis of what went wrong would be a good start.