CENTRAL

BANKING

Week 5
CENTRAL BANKS

• Among the most important players in financial markets throughout the world are
central banks, the government authorities in charge of monetary policy.
• Central banks’ actions affect interest rates, the amount of credit available, and the
money supply, all of which have direct impacts not only on financial markets but also
on aggregate output and inflation.
• To understand the role that central banks play in financial markets and the overall
economy, we need to understand how these organizations work. Who controls central
banks and determines their actions? What motivates their behavior? Who holds the
reins of power?
ROLE OF CENTRAL BANKS

• The role of a central bank is typically threefold: to manage the money supply; to act as a
lender of last resort; and to regulate the financial industry. (The regulatory responsibility is
often shared with other arms of government.) In the United States, the Federal Reserve has
the added mission of using monetary policy to promote full employment.
• A central bank can prevent panics, smooth economic fluctuations, and protect the value of a
fiat currency. Of course, central banks can also commit monetary malpractice. Zimbabwe’s
central bank wrecked the economy with too much money; in the United States during the
1930s, the relatively young Federal Reserve allowed the money supply to shrink
precipitously, turning what might have been a routine economic downturn into the Great
Depression.
• Yes, a doctor can cure cancer; he can also amputate the wrong limb. So it is with central
bankers.
CENTRAL BANKS & THEIR
RESPONSIBILITIES

• A central bank is a public institution that is responsible for implementing monetary

policy, managing the currency of a country, or group of countries, and controlling the
money supply. Some of the main responsibilities central banks have are:
1. Defining monetary policy: Central banks set macroeconomic objectives such as
to ensure price stability and economic growth. To do this, financial authorities have
tools like setting official interest rates, which have an impact on the cost of money.
Based on the economic situation, central banks will opt to either increase official
interest rates (to control inflation, for example) or decrease them (to encourage
consumption and boost economic growth)
2. Regulating money in circulation: They are the authority for issuing coins and
notes, the money supply, and for regulating how much money is in circulation.
Central banks do this to inject liquidity into the economy so that different economic
agents (families, companies and States) can use it in their transactions. With regard
to currencies, central banks are also responsible for carrying out operations to
ensure that exchange rates remain stable.
CENTRAL BANKS & THEIR
RESPONSIBILITIES

3. Overseeing the inter-bank market: They ensure that the relevant financial laws
are respected and they monitor national payment systems to make sure that they
are working properly.
4. Loaning liquidity to commercial banks if necessary for solvency issues:
Aside from the loans made between institutions in the inter-bank market,
commercial banks can also receive liquidity from central banks in exchange for
collateral, such as guaranteed public bonds. This means that, if required,
commercial banking institutions can cover what they need in the short-term.
5. Taking on an advisory role: They regularly produce studies and reports that are
useful for governments or private organizations.
THE EUROPEAN CENTRAL BANK, THE EURO
SYSTEM, AND THE EUROPEAN SYSTEM OF
CENTRAL BANKS

• The European Central Bank (ECB) came into existence on June 1, 1998, in order to handle the
transitional issues of the nations that comprise the Eurozone.
• Initially, in January 1, 1999, only 11 EU member states had adopted the euro. This was the date
when the responsibility for conducting monetary policy was transferred from the National
Central Banks (NCBs) of these 11 nation-states to the ECB.
• All of the Eurozone or euro area countries—that is, the EU countries that have adopted the
euro—retain their own National Central Banks and their own banking systems, albeit that the
Eurosystem’s rules and monetary policy are set centrally by the ECB.
• The Eurosystem comprises the ECB and the NCBs of those EU member states that have
adopted the euro.
• Since not all of the EU member states have adopted the euro, the European System of
Central Banks (ESCBs) was established alongside the Eurosystem to comprise the ECB and the
NCBs of all EU member states whether or not they are members of the Eurozone.
EU: YES.
EUROZONE: NO

• Currently, the euro (€) is the

official currency of 20 out of 27 EU
member countries which together
constitute the Eurozone, officially
called the euro area.
• The seven non-eurozone members
of the EU are Bulgaria, Czech
Republic, Denmark, Hungary,
Poland, Romania, and Sweden.
They continue to use their own
national currencies.
DECISION-MAKING BODIES OF THE
ECB

• The three main decision-making bodies of the European Central Bank are the
Governing Council, the Executive Board, and the General Council.
• The Governing Council is the chief decision-making body of the ECB responsible for
formulating monetary policy in the euro area. It consists of the ECB’s president and
vice-president, four members of the Executive Board as well as the governors of the
20 National Central Banks of the euro area countries.
• The main function of the Governing Council of the ECB is to conduct monetary
policy, and its primary objective is to maintain price stability in the euro area.
DECISION-MAKING BODIES OF THE
ECB

• The European Council appoints the Executive Board of the ECB.

• The Executive Board of the ECB is responsible for the day-to-day operations and
management of the ECB and the Eurosystem.
• The third decision-making body is the General Council of the ECB, which
comprises the president and the vice-president of the ECB in addition to the
governors of the NCBs of the 27 EU member states.
• The main task of the General Council is to encourage cooperation between the
National Central Banks of the member states of the EU. The General Council also
performs a number of important advisory functions such as collecting statistical
information for the ECB, preparing the ECB’s annual reports, and standardizing the
accounting and reporting operations of the NCBs.
H O W M O N E TA RY P O L I C Y I S
CONDUCTED WITHIN THE ECB

• The aims of the ECB are similar to those of any other modern central bank.
• The three main objectives of the ECB are to maintain price stability in the economies
of the EU, support the economic policies of the Eurozone nations, and ensure an
independent and open market economy.
• Since price stability is very important in order to attain economic growth and job
creation, the ECB endeavors to maintain its independence from governments.
• To achieve its primary objective of price stability, the ECB aims to maintain a
medium-term inflation rate closely below 2%.
E C B : U N C O N V E N T I O N A L M O N E TA RY
MEASURES

• Since the intensification of the global financial crisis in September 2008 and the series
of European debt crises, the ECB has introduced a number of unconventional or non-
standard monetary policy measures to complement the regular operations of the
Eurosystem when standard monetary policy has become ineffective at combating a
falling money supply and economic recessions.
• The first of these unconventional monetary policy measures include emergency
liquidity assistance (ELA)—that provides liquidity and loans exceptionally to solvent
banking and financial institutions that are facing temporary liquidity problems.
• Second, the ECB has pursued quantitative easing (QE), where central banks buy
sovereign bonds and/or other financial assets from commercial banks and financial
institutions to increase money supply and stimulate the economy.
• All of these non-traditional monetary policy tools were temporary and aimed at
providing liquidity to financial markets and reducing pressures on interest rates.
THE FEDERAL RESERVE BANK (FED)

• The Federal Reserve System, also known as the Federal Reserve bank or the
Fed for short, is one of the largest and most influential central banks in the
world.
• The Fed is subject to oversight from Congress that periodically reviews its
activities, but its decisions are made totally independent of the U.S.
government.
• There are 12 regional Federal Reserve banks located in major U.S. cities.
These regional Federal Reserve banks act as the operating arm of the Fed
that carry out most of its activities and implement the Fed’s dual mandate of
long-term price stability and macroeconomic stability through creating jobs.
THE FEDERAL RESERVE BANK (FED)

• The Federal Reserve System consists of the following:

1. The Federal Reserve Board of Governors (FRB), which mainly assumes
regulatory and supervisory responsibilities over member banks.
2. The Federal Open Market Committee (FOMC): comprises 12 members—
seven members of the Federal Reserve Board of Governors, president of the
Federal Reserve bank of New York, and 4 of the regional Federal Reserve
bank presidents.
3. The 12 Federal Reserve banks that are located in major cities throughout
the nation
FED EXPLAINED

• The Fed has a board that is

comprised of seven members.
There are also 12 Federal
Reserve banks with their own
presidents that represent a
separate district.
SIMILARITIES BETWEEN THE ECB AND
THE FED

• Both the ECB and the Fed are entities that bind a number of regional central banks
together, 20 National Central Banks for the ECB and 12 regional Federal Reserve
banks for the Fed.
• Both are independent institutions with a decentralized structure that employs basic
monetary tools such as legal reserve requirements, interest rates, and open market
operations.
• The ECB was designed according to the German Model, which supports political
independence and makes monetary policy decisions independent of political
authorities. This suits the state of affairs of the ECB where the interference of
multiple EU governments is apt to disrupt operations. Similarly, the Fed is highly
independent of the government and reports to the Congress
DIFFERENCE BETWEEN THE ECB AND
THE FED

1. First, the ECB and the Fed have different mandates or objectives and accordingly
adopt different methods to achieve these objectives. As mentioned before, the
primary objective of the ECB is to achieve price stability. On the other hand, the Fed’s
dual mandate and monetary policy objective is to deliver price stability and
consequently to support the macroeconomic objectives including those for growth
and employment. Hence, unlike the ECB, the Fed often ignores the temporary effects
of price changes since it considers unemployment to be a much bigger priority.
2. Second, the Board of Governors controls the budgets of the Federal Reserve banks,
whereas the National Central Banks control their own budgets and the budget of the
ECB in Frankfurt. The ECB in the Eurosystem, therefore, has less power than does the
Board of Governors in the Federal Reserve System.
THE BANK OF ENGLAND

• The British central bank or the Bank of England (BoE), known as the “Old Lady” of
Threadneedle Street, was founded in 1694. Being the second-oldest central bank in
the world, its model has been the basis of most other central banks of the world.
• The Court of Directors (equivalent to a board of directors) of the Bank of England
comprises five executive members from the Bank, including the governor and two
deputy governors, and up to nine non-executive members. It is accountable to the
Parliament. The King upon the recommendation of the prime minister appoints all
members of the Court.
• Because the United Kingdom is not a member of the euro area, the Bank of England
makes its monetary policy decisions independently from the European Central Bank.
The Bank’s Monetary Policy Committee (MPC) is responsible for conducting monetary
policy.
THE BANK OF ENGLAND

• Raising and lowering interest rates is the main policy tool that the BoE uses for
controlling growth. The lower the interest rate, the more people are encouraged to
spend and investors to invest.
• However, as interest rates were cut close to zero since the global financial crisis,
many central banks including the BoE have used quantitative easing, which is an
unconventional form of monetary policy where a central bank creates new money
electronically to buy financial assets from businesses.
YO U R TA S K :

• Visit SBP’s website and familiarize yourself with its objectives and functioning. Also,
try to compare and contrast those features with other central banks.
STRUCTURE AND INDEPENDENCE OF
CENTRAL BANKS OF EMERGING
MARKET ECONOMIES

• Emerging market economies (EMEs) are those economies of Asia, Latin America, and
Eastern Europe that are growing at a fast rate and are experiencing booming industrialization
and increased exports.
• To cater to their rapid macroeconomic growth, the financial markets and banking sectors of
EMEs are swiftly maturing.
• In addition to the traditional central banking functions—monetary policy, bank supervision and
regulation, and overseeing the payments system—central banks of EMEs vigorously build and
reform the financial infrastructure of their countries, continuously develop their financial
markets, and directly help with macroeconomic development.
• Moreover, central banks of EMEs manage foreign exchange reserves and implement policies
that also help promote growth and exports. Thus, most of the foreign exchange decisions are
taken in collaboration with the government.
STRUCTURE AND INDEPENDENCE OF
CENTRAL BANKS OF EMERGING
MARKET ECONOMIES

• The main developmental roles that central banks of EMEs assume are enhancing credit
flow to productive fast-growing export-oriented industries and employment intensive
sectors, mainly agriculture, and small and micro and enterprises.
• They also subsidize banks when they make affordable housing and education loans. Since
the agricultural sectors of EMEs are underbanked, their central banks try to increase
access to affordable financial services, promote financial education and literacy, and
support small local, rural, and cooperative banks.
• All of these strategies are known as “financial inclusion policies.”
• As such, central banks in EMEs have less independence because many decisions regarding
foreign exchange, developing financial institutions and markets, and extending loans to
priority regions and sectors need to be made jointly with the government.
CENTRAL BANKS INDEPENDENCE

• During the last four decades, both theory and empirical evidence have suggested
that the more independent a central bank, the more effective monetary policy is.
• There are two key dimensions of central bank independence.

1. The first dimension, goal independence, encompasses those institutional

characteristics that insulate the central bank from political influence in defining its
monetary policy objectives.
2. The second dimension, instrument independence, refers to the ability of the
central bank to freely implement policy instruments in its pursuit to meet its
monetary goals.
The degree of independence of central banks depends largely on the preferences and
circumstances of each nation.
THE CASE FOR INDEPENDENCE

• The main argument for central bank independence focuses on potential inflationary
biases that are likely to exert themselves as a result of political pressure to boost
output in the short run—mainly before elections—in order to finance government
spending to lower unemployment and interest rates. This is apt to lead to a political
business cycle, in which these expansionary monetary policies are reversed after the
election to limit inflation, unnecessarily leading to macroeconomic instability or
booms and busts.
• Another argument for central bank independence is that the public not only generally
distrusts politicians concerning making politically motivated decision, but also due to
their lack of expertise in conducting monetary policy.
THE CASE AGAINST INDEPENDENCE

• Monetary policy has failed several times, most notably during the Great Depression
of the 1930s. Monetary and fiscal policies should work together; when each is
controlled separately, they might well pull in opposite directions; and there may be
evidence that monetary policy needs political intervention to ensure it helps all
members of society, not just a few.
M O N E TA RY
POLICY &
CENTRAL
BANKING
CENTRAL BANKS

• Central banks have evolved in different countries in different ways. (The European
Central Bank, for example, was created to manage monetary policy in all the countries
that share the euro.) Central banks are government entities. They are created and
empowered by national governments. The senior Federal Reserve Board members,
including the chair, are appointed by the president and confirmed by the Senate. Once
in office, however, they cannot be removed by the president or Congress for any policy-
related decisions.
• Why does that matter? Because doing what is best with regard to monetary policy is not
always about doing what’s popular. In fact, if economics nerds—of which there are many
—had a central banking superhero, it might be Inflation Fighter Man. This superhero
would have a single power, raising and lowering interest rates, and with that power he
could whip rising prices into submission.
H O W D O E S I N F L AT I O N F I G H T E R M A N
WORK?

• Unions demanding higher wages? Boom! Inflation Fighter Man raises interest rates
until the economy slows to the point that workers fear for their jobs. Forget the
double-digit raise! Once Inflation Fighter Man tightens the screws on monetary policy,
workers are happy just to be employed at whatever wage they made last year.
• Companies looking to raise prices? Pow! Inflation Fighter Man makes it so expensive
for consumers to borrow that homebuilders and auto manufacturers and other
businesses dependent on consumer credit must hold prices down to stay in business.
• Doesn’t sound like a hero? That’s the point! Let’s delve deeper.
H O W D O E S I N F L AT I O N F I G H T E R M A N
WORK?

• Like any good superhero, Inflation Fighter Man has a dark side. Fighting inflation inflicts
pain. Raising interest rates deliberately slows the economy: consumers purchase less, asset
prices fall, firms find it more expensive to borrow and invest. Entire industries, such as real
estate, fall into distress. This special power—manipulating interest rates—can impose real
costs on real lives.
• Inflation Fighter Man knows that price stability is what maximizes prosperity in the long run.
Inflation Fighter Man is not cowed by personal attacks and emotional stories of economic
distress. He knows that society will be better off when the system is rid of inflation—and
the expectation of inflation—once and for all. Then households will no longer see the value
of their savings eroded by inflation; businesses can make plans knowing what prices will be
five, ten, or even thirty years in the future. Sure enough, when the world emerges from an
inflationary period, people everywhere say, “Thank you, Inflation Fighter Man.”
SO WHO IS
I N F L AT I O N
FIGHTER MAN?

• Paul Volcker was chair of the Federal

Reserve, America’s central bank, from
1979 to 1987.
• In 1980, inflation in the United States
was running at 14 percent.
• The economy was also weak, defying
expectations that inflation should be
good for growth and employment.
Inflationary expectations were baked
into the cake. Everyone expected price
increases, which brought about price
increases, which planted inflationary
expectations ever more deeply.
W H AT D I D PA U L V O L C K E R D O ?

• Something would have to change to break the back of inflation. Not only would that
require a drastic dose of higher interest rates, but the public would have to believe
that the Fed would tolerate the economic pain associated with a sustained period of
high interest rates.
• The prime lending rate peaked at 21.5 percent (Dec 1980). Unemployment reached
double digits in some months. . . . Volcker’s tough medicine led to not one, but two,
recessions before prices finally stabilized.”
• The result of this bitter medicine was three decades of modest inflation and economic
stability that came to be known as the Great Moderation.
 I N F L AT I O N F I G H T E R M A N
V S D E F L AT I O N F I G H T I N G
WOMAN?

• Janet Yellen took over as chair of the

Federal Reserve in 2014, the first woman to
hold that post.
• Meanwhile, the world has emerged from the
financial crisis of 2008 facing a different
threat than it did in the 1970s: falling
prices.
• In the United States, Europe, and Japan,
monetary policy officials are working hard
to ward off deflation. Governments are
consistently missing their inflation targets—
on the low side.
• In early 2015, a full seven years after the
onset of the financial crisis, the Economist
I M P O RTA N C E O F C B C H A I R S & T H E I M PA C T O F
THEIR POLICIES ON GLOBAL ECONOMIC
ENVIRONMENT

• In real life, central banks have become some of the world’s most important economic institutions. With
currencies backed only by the paper on which they are printed, a responsible central bank is all that
stands between stable prices and Zimbabwe-like hyperinflation. (Yes, Zimbabwe had a central bank—
just not a good one.)
• The people who lead central banks have striking amounts of unchecked powers by democratic
standards. Ben Bernanke steered the global economy through the financial crisis, drawing on his
experience as a scholar of the Great Depression so as not to repeat the monetary mistakes made then.
• Janet Yellen has had to deal with slowly reversing the extraordinary measures taken post-2008 and the
specter of deflation.
• In Europe, Mario Draghi, president of the European Central Bank, was trying to hold the euro together,
as countries like Spain, Portugal, Italy, and Greece struggled with the burdens imposed by a single
supranational currency.
• The degree to which these central bankers succeed or fail affects the fate of the global economy—
employment, bankruptcies, wealth, even war and peace.
T O O L S O F M O N E TA RY P O L I C Y

• By using the following tools, central banks can influence the money supply, inflation, and
interest rates to achieve their policy objectives, such as promoting economic growth,
maintaining price stability, and ensuring financial stability.

1. Open market operations: Central banks can buy or sell government securities on the open
market to influence the money supply and interest rates.

2. Reserve requirements: Central banks can set reserve requirements for commercial banks, which
determine the amount of reserves that banks must hold as a percentage of their deposits.

3. Discount rate: Central banks can set the discount rate, which is the interest rate at which
commercial banks can borrow funds from the central bank.

4. Forward guidance: Central banks can communicate their future monetary policy intentions to
guide market expectations and influence interest rates.

5. Quantitative easing: Central banks can purchase large quantities of government securities or
other assets to inject liquidity into the financial system and stimulate economic activity.
CRR & SLR

• Reserve requirement is a monetary policy tool used by central banks to regulate the
amount of money that commercial banks can lend out. It is the percentage of a bank's
deposits that must be held in reserve, either as cash or as deposits with the central bank.
By adjusting the reserve requirement, the central bank can influence the amount of money
that banks can lend out, and therefore, control the overall money supply in the economy.
• Cash reserve ratio (CRR) is a type of reserve requirement that requires commercial
banks to maintain a certain percentage of their deposits as cash reserves with the central
bank. This cash reserve can only be used to meet the day-to-day cash demands of the
bank's customers and cannot be lent out or invested.
• Statutory liquidity ratio (SLR) is another type of reserve requirement that requires
banks to maintain a certain percentage of their deposits as liquid assets such as
government securities, gold, and other approved securities. SLR ensures that banks have
sufficient assets that can be quickly converted into cash to meet the demands of their
depositors.
Quantitative Easing:
• In recent times, quantitative easing (QE)
has been used when economic activity is
sluggish and there is a fear of deflation or
recession.
• QE involves the creation of new money—
usually in the form of electronic currency—
which the central bank then uses to buy
government bonds or bonds from investors
such as banks or pension funds.
• The aim is to increase the liquidity of money
in the economy which will in turn lower
interest rates and make lending easier and
more attractive. This, in turn, should
encourage businesses to invest and
consumers to spend more, thus boosting
the economy.
MANAGING PRICES

• The supply of fiat currency is essentially infinite; someone has to mind the store.
• A primary goal of a central bank is to maintain the value of the currency. Most central
banks do not aim for zero inflation. Instead, they advertise an inflation target, or an
inflation range. The U.S. Federal Reserve has a stated inflation target of 2 percent.
The European Central Bank has a target of “below, but close to 2 percent.” New
Zealand has a target range of 1 to 3 percent. And so on.
• From there, it becomes like a carnival game: raise or lower interest rates to keep
inflation near the target or in the range. (As noted above, raising interest rates is
typically referred to as tightening monetary policy and lowering rates as loosening it.)
Here is how it generally works.
MANAGING PRICES

• 1. Any economy has a “speed limit” in the short run—a relatively fixed capacity to produce goods
and services. In the short run, we have a finite supply of the things the economy needs as it
expands: land, workers, steel, yoga instructors, and so on. If the demand for goods and services
exceeds our capacity to produce them, prices will rise. That is how businesses ration scarce
products. A shortage of steel leads to higher steel prices. Conversely, when there is slack in the
economy, prices tend to fall. If an auto dealer has inventory that is not moving, he marks down
prices. If apartments are sitting empty, rents tend to fall.
• 2. The price of credit affects the demand for goods and services. You are more likely to buy a new
Mercedes if you can finance it for 2 percent instead of 5 percent. The same is true for buying homes,
washing machines, or anything that is typically financed. On the business side, firms find it cheaper
(and therefore more profitable) to expand when interest rates fall (other things being equal).
• 3. Central banks manage the price of credit (interest rates) to keep an economy running as close to
its speed limit as possible. If an economy “overheats”— meaning that demand exceeds what can be
produced—prices across the economy will go up: inflation. On the other hand, if an economy grows
more slowly than its potential, resources will sit idle. Factories close; workers are unemployed. The
excess capacity causes prices to fall: deflation.
T H E T W O M E A S U R E S O F I N F L AT I O N

• Like most carnival games, hitting an inflation target is harder than it may first appear. Let’s
start with the most basic challenge when it comes to maintaining stable prices: Which prices?
• Headline inflation is the overall inflation rate that is reported in the news and often used as
a measure of price changes in an economy. It includes all the goods and services that are part
of the consumer price index (CPI) basket, which is a representative basket of goods and
services that consumers typically purchase. Headline inflation can be influenced by temporary
factors such as changes in food and energy prices, which can be volatile and subject to
seasonal fluctuations.
• Core inflation, on the other hand, is a measure of inflation that excludes the most volatile
components of the CPI basket, such as food and energy prices. By removing these volatile
components, core inflation is believed to provide a more accurate measure of the underlying
inflation trend in an economy. This can be particularly useful for policymakers in making
decisions about monetary policy, as it helps them to identify whether inflation is being driven
by short-term fluctuations or longer-term trends.
THE FED DOES NOT RESPOND TO WHERE PRICES ARE;
THEY RESPOND TO WHERE THEY THINK PRICES ARE
GOING.

• Just about everything related to monetary policy happens with a lag, meaning that some
time elapses between cause and effect. If the corn crop is lousy in the Midwest this summer,
food prices might be higher this fall, or next year, or some combination of both. An
extraordinary amount of research and analysis at the Fed goes into figuring out where the
prices are going.
• Before each FOMC meeting, Fed officials prepare a report called “Current Economic and
Financial Conditions,” or the “Greenbook” because of its green cover. (These people have a
lot of work to do, leaving very little time for creativity.)
• The goal is to summarize the domestic and international economic forces relevant to Fed
policy. This analysis is used to create a report called “Monetary Policy Alternatives,” or the
“Bluebook,” which lays out the monetary policy alternatives that the FOMC could consider at
the upcoming meeting.
QUEEN’S QUESTION

• In 2008, Queen Elizabeth II famously asked professors at the London School of

Economics (LSE) about the global financial crisis: “Why did no one see it coming?”
• If Charles III were following in the footsteps of his mother, he would surely ask a
similar question today, but about high inflation.
IT’S TIME TO RETHINK THE
F O U N D AT I O N A N D F R A M E W O R K O F
M O N E TA RY P O L I C Y

• This question is more compelling for two reasons.

• First, before the recent inflation spike to levels not seen in 40 years, many central
banks in advanced economies were overwhelmingly concerned about low inflation.
• Second, they confidently contended that inflation was transitory and failed to restrain
it even as prices rose rapidly.
• The triggering events, notably trade and production disruption owing to the
pandemic and the war in Ukraine, were supply-side events.
• These were considered outside the remit of monetary policy. But the impact of
triggering events on inflation varies according to preexisting financial conditions,
which are in turn shaped by monetary policy.
• Central bankers, therefore, are not entirely blameless.
G R E AT M O D E R AT I O N O F 1 9 8 0 S

• Perhaps central bankers simply had it too easy during the “Great Moderation,” the 20 or so
years of steady growth and stable inflation that began in the mid-1980s.
• The global economy benefited from favorable supply-side factors, such as the entry of
developing and former socialist economies into the global market economy, rapid advances
in information technology, and a relatively stable geopolitical environment. These factors
enabled low inflation and relatively high growth to coexist. Central banks’ job did not require
much of a political mandate.
• After experiencing those peaceful times, when central bank independence came to be widely
accepted, central banks started to deploy unconventional monetary policy. There was a
somewhat naïve assumption that the policy could be unwound easily enough when
necessary. Unfortunately, the world has changed. The environment that fostered benign
supply-side factors is under attack from many directions: heightened geopolitical risk, rising
populism, and the pandemic have disrupted global supply chains. Central banks now face a
trade-off between inflation and employment, which makes unwinding very challenging.
UNFOUNDED FEAR

• The conventional fear of deflation and interest rates falling to their lowest level
possible (the so-called zero lower bound) was well articulated in a speech by Jay
Powell, Federal Reserve chairman, at the August 2020 Jackson Hole conference:
• “[I]f inflation expectations fall below our 2 percent objective, interest rates would
decline in tandem. In turn, we would have less scope to cut interest rates to boost
employment during an economic downturn, diminishing our capacity to stabilize the
economy through cutting interest rates. We have seen this adverse dynamic play out
in other major economies around the world and have learned that once it sets in, it
can be very difficult to overcome. We want to do what we can to prevent such a
dynamic from happening here.”
CHALLENGES FOR CENTRAL BANKS

• When Covid-19 hit four years ago, we found ourselves in uncharted waters. The
pandemic was a truly exogenous shock: a recession ensued from the drastic public
health measures that were required.
• Information about the virus and its impact on the economy became available only as
time passed, and it was and continues to be imperfect. Acting under this uncertainty,
the policy responses were fast and bold, taking some calculated risks. Policymakers
recognised that, after the economy had been deliberately put into a coma, it would
need all the life support it could get in order to avoid bankruptcies and worker
displacement.
• They were under no illusions: such measures would come at the cost of higher public
debt, to say nothing of potential financial distortions and allocative inefficiency. But
their thinking was, and rightly so, that any inaction on their part would have led to far
worse outcomes.
CHALLENGES FOR CENTRAL BANKS

• So, central banks deployed their full arsenal of tools. They tailored their response to
the nature of stress experienced in each country and the structure of their financial
systems.
• This was complemented with supervisory flexibility, to support banks' ability and
willingness to lend. The fiscal policy response too was swift and forceful.
• But the faster recovery has come with some surprises: it has unleashed inflation,
which in most advanced economies had been all but absent for nearly a decade.
Deciphering the drivers of that inflation has been challenging.
• In some economies, signs of labour shortages have also appeared, attributable to an
increase in reservation wages, falling participation rates and skill mismatches.
S O W H AT ’ S N E X T ?

• Central banks need to assess how robust the recovery is and urgently address
inflation – while managing the effects of Omicron and any yet-to-emerge Covid
variants.
• Household income has held up, but with fiscal support coming to an end and
accumulated savings being drawn down, consumption could take a hit.
• With businesses in many countries already heavily indebted before the pandemic –
and leverage having increased further, corporate investment may be low.
P O L I C Y I M P L I C AT I O N S

• The pandemic and war have further challenged central banks. Those in advanced
economies had focused in recent years on providing enough stimulus to support growth
and boost low inflation. The task was to deliver the firepower needed through near-zero
interest rates when inflation seemed destined to remain too low.
• Now, these crises underscore for central banks that managing risks means accounting for
inflation that’s too low or too high—and the possibility of stronger tensions between the
objectives of price stability and employment or growth.
• Beyond these lessons, there are concerns that the pandemic and war may lead to larger
supply shocks, and less-anchored inflation expectations. These risks are biggest for
emerging markets, especially those with high debt. But with the fastest inflation in
decades, advanced economy central banks also face significant risks, which is why they
need to stay the course and maintain restrictive monetary policy rates until they see
durable signs of inflation returning to target. We can’t have sustained economic growth
B R I N G I N G E U R O A R E A I N F L AT I O N
B A C K T O TA R G E T

• The European Central Bank (ECB) is on the front line of the fight against inflation.
• Policymakers raised interest rates to 15-year highs to bring euro area inflation, which peaked
at more than 10 percent in October 2022, back to the 2 percent target.
• Inflation is expected to slow this year, but monetary policy will continue to attract scrutiny as
the continent’s economic growth slows, consumers continue to struggle with the cost-of-living
crisis, and governments seek to finance large debts in a new era of higher interest rates.
• The worst-case scenario for a central bank is that a prolonged phase of high inflation causes
the public to lose confidence that price stability (in practice, a 2 percent inflation target) will
be maintained over the medium term.
• If the public comes to believe that inflation will remain high on an indefinite basis, this would
be baked into price and wage setting and become self-sustaining. So it is essential that
monetary policy is clearly set to make sure that inflation returns in a timely manner to our 2
percent target.
H O W H A S M O N E TA RY P O L I C Y B E E N U S E D
R E C E N T LY ?

• After the global financial crisis that started in 2007, central banks in advanced
economies eased monetary policy by reducing interest rates until short-term rates
came close to zero, limiting options for additional cuts.
• Some central banks used unconventional monetary policies, buying long-term bonds
to further lower long-term rates.
• In response to the COVID-19 pandemic, central banks took actions to ease monetary
policy, provide liquidity to markets, and maintain the flow of credit.
• More recently, in response to rapidly growing inflation, central banks around the
world have tightened monetary policy by increasing interest rates.
M O N E TA RY & F I S C A L I N T E R A C T I O N
• Q: Rising interest rates are piling pressure on households across countries. Do central
banks have any role to play in lessening that pressure, or is it something that should
be left entirely to governments and fiscal policy?
• A: All households benefit from medium-term price stability. The poor are the hardest
hit by persistent inflation. CBs should be efficient in their monetary policy: delivering
their targets (2% infl in Eurozone, for example).
• In analyzing the transmission of monetary policy, CBs should closely examine the
impact of interest rate movements on households: not only the direct effects (savers
& borrowers) but also the indirect effects through the impact of monetary policy on
output and employment.
• These vary between those who work in the sectors most sensitive to interest rate
movements (such as construction and consumer durables) and those who work in
less cyclical industries. Governments should always protect the most vulnerable in
society, but fiscal measures that directly offset the impact of interest rate