Central banks are the guardians of money, the cornerstone of capitalism. Their actions influence people’s wages and savings, whether they can borrow and at what cost, and steer the overall direction of the economy. Whether you are an employee or a retiree, a saver or a borrower, their decisions concern you.
Thirty years ago, after inflation in the rich world hit double-digit highs, these powers were harnessed for one purpose: to maintain price stability. Most central banks have been given strict mandates and have become independent from prying, vote-seeking politicians.
For a time, it seemed that this ingenious political solution had banished the specter of inflation altogether. Everywhere, central bank targets have shaped expectations of higher prices. Inflation in America, Britain, Germany and Japan averaged 2.1% per year between 1990 and 2007, compared to 8% in the 1970s. Before Covid-19 hit, the great concern was that inflation was too low, not too high.
Today, however, the inflation-fighting regime faces its most spectacular failure yet. Inflation has returned with a vengeance, boosted by soaring energy prices, rising wages and supply chain disruptions. In America and the eurozone, consumer prices rose at an annual rate above 7% in March, the fastest pace in decades. Labor markets in many places have become uncomfortably tight as jobs are driving away too few workers. Even the Bank for International Settlements (BIS), the central bank of central banks, warns that the world could be on the cusp of a new inflationary era. Monetary policymakers in the rich world are scrambling to respond.
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This special report notes that this threat to the credibility of central banks comes as they have extended well beyond the simple fight against inflation. After the 2007-09 financial crisis, their regulatory authority was strengthened. During the pandemic, they have intervened in a wide range of asset markets, sucking up government bonds and even lending directly to companies and governments. Lulled by latent inflation before the pandemic, they have become versatile policymakers, venturing to address structural issues such as inequality and climate change. As inflation returns, the danger is that these new goals will impede or distract from the core mission of taming it.
An expansive phase
The powers of central banks have risen and fallen over time, especially after crises. The Riksbank of Sweden, the first central bank, was established in 1668 “to maintain the national currency at its fair and just value”. The Bank of England was created in 1694 to finance the war against France. Other central banks followed, although the Federal Reserve was not created until 1913. A series of financial panics in the 19th century led central banks to become lenders of last resort, ready to prop up the banking system in the event of a crisis. To ensure confidence in silver, most pegged their currency to gold.
In the depression of the 1930s, the gold standard collapsed, central banks were disgraced and a period of subservience to governments ensued. During World War II, they kept public borrowing costs low. Many have turned to industrial policy. In emerging markets, they have come to resemble national development banks. (A branch of Mexico’s central bank financed the construction of tourist resorts in Cancún.) But as inflation rose in the 1960s and 1970s, the tide turned in favor of their independence.
In the United States, the Fed and the Treasury have agreed that the central bank will no longer cap government bond yields. The Fed made a strong display of its independence in the early 1980s, when Paul Volcker caused a recession to control inflation. Central banks were granted independence and inflation targets, first in the wealthy world and later in many emerging economies. Today, most are independent (the People’s Bank of China, or PBOC, is an exception).
Why is the role of central banks swelling again? One reason is the steady decline in interest rates as desired global savings rose, which made it harder to revive inflation after the financial crisis. In 2000, the Fed’s benchmark rate was around 6%. Today it is 0.25 to 0.5%. Although the central bank has started raising interest rates, investors expect them to peak at just 3.1% in two years. As they tried to revive inflation, central banks resorted to all sorts of tools. Many wealthy countries have started buying government bonds to drive down long-term interest rates. The European Central Bank (ECB) bought corporate papers and subsidized bank lending to households and businesses. The Bank of Japan went further, buying exchange-traded funds and promising to keep ten-year government bond yields at 0.25%.
Another reason for the growing role of central banks is the new focus on financial stability, after a period of neglect. Stricter regulation of banks has led to an increase in non-bank intermediaries in a range of credit markets. When the crisis arrived, central banks had to stabilize these markets. The extraordinary liquidity crunch caused by the 2020 lockdowns has pushed central banks back into the sphere of credit allocation. Technological change has accelerated the decline of cash, which once embodied trust in central banks. This has led central banks to question whether the notes they provide to the public should become virtual.
Politics is another reason for the larger footprint of central banks. One sign is that appointing Fed governors has become more difficult since the financial crisis. Faced with big, intractable problems such as climate change and inequality, ministers and campaigners are also eyeing huge central bank balance sheets, hoping to use them to achieve socially dignified or green goals. Central bankers talk a lot more about these issues. Rising global tensions have also forced some to go beyond technical risk management when managing their foreign exchange reserves, towards geopolitics.
Many emerging markets have embraced inflation targeting, shedding their developmental role and thus benefiting from lower and less volatile inflation. But they keep a firmer hand on the markets, given their vulnerability to exchange rate movements and capital outflows. Some remnants of the old industrial policy remain, such as bank loan quotas for farmers or rural borrowers in India. The PBOC pursues several objectives, often at the request of the government. Although it has liberalized interest rates somewhat, it relies heavily on managing the quantity of credit rather than its price, pushing banks to lend to certain preferred borrowers.
This special report examines five areas where central banks are under pressure to do more: intervene in financial markets; fight against inequalities; fighting climate change; the introduction of digital currencies; and react to geopolitics. Each represents a significant change in markets and the economy. But each also risks dragging central banks deeper into the political arena, which would result in a loss of focus. When inflation was low, a larger role might have seemed innocuous. Now, however, he has come up against the reality of high inflation. The danger is that with too many objectives, central banks fail in their most important mission.
© 2022 The Economist Newspaper Limited. All rights reserved. Excerpt from The Economist published under licence. The original article can be found at www.economist.com