Central banking after the crisis: The challenges ahead

The global financial crisis of 2008 has called into question several long-held assumptions of central banking and underscored the challenges as banks seek to absorb its lessons for preventing – or at any rate minimising the probability of – another crisis.

In the years before the crisis, monetary policy was focused on pursuing a single objective: price stability – using a single instrument: the short-term interest rate.

The crisis was a powerful reminder that price stability does not guarantee financial stability and that the task of central banks must also include watching over the health of the financial system.

There are many causes behind the crisis and central banks have to take some blame.

The main charge is that they failed to see the impact of globalisation on inflation, to see the disconnect between asset price inflation and consumer price inflation, and to act to contain a credit-financed boom.

These pre-crisis failures of central banks, as well as their success in mitigating the impact of the crisis, speak to fundamental issues going forward – their mandates, objectives, tools, and independence.

Globalisation’s impact

The seeds of the crisis came amid structural shifts in the global economy that gathered force with the entry of China and India into the market.

ThinkAloud4Labour supply grew and global trade and finance exploded, fuelling imports by the advanced economies, especially the US whose current account deficit expanded rapidly.

In theory, the dollar should have weakened, and consumer prices and real wages should have risen. However, the productivity and efficiency gains resulting from globalisation had a powerful deflationary impact.

Meanwhile, Asian economies that were running current account surpluses invested in US Treasuries driving interest rates to historic lows and sparking a search for yield.

As asset prices surged, the financial sector responded by designing increasingly complex products until, ultimately, the bubble burst in 2008.

The irony for central banks was that their exclusive concern with consumer price inflation had actually resulted in asset price inflation and encouraged leverage.

Which direction do central banks now go? Amid the fallout from the crisis, several challenges have emerged as key for central banks in developed and emerging economies.

Unconventional monetary policy

At the height of the crisis, when the US Federal Reserve had no more room to reduce interest rates, it resorted to unconventional monetary policy – or quantitative easing (QE) in this case – buying securities and flooding the market with cash for an extended period.

bank280Emerging economies followed with their own versions of QE. But since then the question of when, why, and how to use such policies has become a focus of increased attention.

The first phase of QE produced modestly successful outcomes. Asset prices went up and interest rates came down, stimulating consumption. The cost of government borrowing fell, yielding space for fiscal stimulus.

However, the marginal impact of subsequent phases of QE remains questionable.

The downside of unconventional monetary policy is that it cannot raise confidence or stimulate demand when households and firms are unsure about economic prospects. Indeed, if continued for too long, it can actually stoke inflation.

One point of view holds that there is no need for QE and mere assurance from the central bank that it will keep interest rates low ‘for an extended period’ is enough to stimulate demand. However, that links to the credibility of the central bank.

The challenge for central banks is to protect their autonomy and avoid being held hostage to political interests while improving their accountability.

There is also the risk that people may hold back buying, preferring to clear existing debt.

Admittedly, QE helps to stabilise the financial system in a crisis but sustained outcomes will follow only if it is accompanied by structural adjustment policies.

In a globalized world it is a challenge to make nationally optimal policies because external developments affect the domestic economy in numerous – sometimes capricious – ways.

For instance, many emerging economies grapple with the question of how to deal with inflation stemming from the exchange rate. Do they use the interest rate, which is the standard monetary policy tool, or do they intervene in the foreign-exchange market? Or do they impose capital controls?

It is important for central banks to deepen their understanding of these interactions and factor in global spillovers into their domestic policies. The challenge is to learn to maximize the benefits and minimize the costs of globalization.

The new “trilemma” and autonomy

In the wake of the crisis, three goals have assumed importance for central banks: price stability, financial stability, and sovereign debt sustainability, the latter coming came to the fore during the European debt crisis.

Banks have to manage this new “trilemma” of objectives without compromising the efficiency of their policies and their autonomy.

Can this be achieved? Is there synergy between policies for these goals or is there tension? The jury is still out.

In pursuing these goals, central banks may sometimes be constrained by what is called the fiscal dominance of monetary policy.

For instance, the ECB has said its bond purchase programme aims to restore liquidity. But many believe this is a thinly veiled attempt to bolster sovereign borrowing and that the ECB is actually acquiescing in fiscal dominance.

This conflict has played out in different ways in the US, Japan, and in India where the central bank ran a tight monetary policy in part to offset the government’s expansionary fiscal policy.

The challenge for central banks is to protect their autonomy and avoid being held hostage to political interests while improving their accountability.

Communication as a policy tool

The crisis has nudged central banks into providing more and clearer information to financial markets and the public. Such communication can have a powerful influence, especially in times of stress.

In 2012, Mario Draghi, president of the European Central Bank, famously said that the bank would do ‘whatever it takes’ to save the euro, helping to prevent what then seemed like an imminent collapse of the currency.

Much of the debate on central bank communication has centred on forward guidance, or future monetary policy.

Markets have two tendencies that complicate this communication: Firstly, guidance usually comes with conditions and caveats but markets tend to ignore the caveat and interpret the statement as an irrevocable commitment.

For example, if the Reserve Bank of India says decline in inflation opens up space for monetary easing ‘subject to external sector conditions’, the market chooses to ignore the caveat about external sector conditions.

And secondly, markets also want central banks to be specific in their forward guidance. But being specific increases the risk of a credibility gap for central banks.

Take the case of the Bank of England. It said last year that it would not raise interest rates until unemployment fell to the 7 per cent level, “which was unlikely to happen until 2016”.

Unemployment in the UK has already fallen below that level, well ahead of the predicted date, but the BoE believes that recovery is not yet complete to warrant raising rates, despite its earlier linking of policy action to a specific outcome.

So the challenge of communication for central banks is to determine what to say, when to do so, and how to say it.

  • Author Profile

    Dr. Duvvuri Subbarao served as Governor of the Reserve Bank of India for five years (2008-2013). Prior to that, he was Finance Secretary to the Government of India and Secretary to the Prime Minister's Economic Advisory Council. He is now a Distinguished Visiting Fellow at NUS Business School.

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