Central Banks Cavalry Can No Longer Save The World by Group Of Thirty
Almost from their beginnings, over three centuries ago, the ultimate objective of central banks has been to support sustainable economic growth through the pursuit of price stability and financial stability. Over time, however, the balance of each goal has fluctuated according to existing cultural, economic, and political pressures.
In the immediate decades prior to the 2007–09 economic and financial crisis, the policy pendulum swung strongly toward favoring price stability, with the focus on the relatively short term. The Great Moderation—a period of apparent relative economic calm and stability—occurred in the advanced market economies (AMEs). This economic stability supported a theoretical view and mindset that saw the economy as being inherently self-stabilizing, and efficient in its allocation of scarce resources. This view prevailed despite building evidence of underlying tensions or imbalances, and the proliferation of localized economic and financial crises. In hindsight, the economic calm obscured a credit bubble that was growing and becoming precarious. When the bubble collapsed, the crisis erupted and central banks and governments responded swiftly.
During the response to the economic and financial crisis, central banks played an essential crisis management role alongside governments. Central banks in the major AMEs reacted with vigor. Policy rates were reduced essentially to zero, forward guidance was used to help lower medium-term rates, and the balance sheets of central banks expanded enormously, while their composition altered significantly. Central banks fought to restore financial stability, and aggressive unconventional policy action was necessary and effective in the crisis response phase, in particular. Collectively, central bank policies since the outbreak of the crisis have made a crucial contribution to restoring financial stability.
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In 2015, eight years on since the eruption of the crisis, the central banking community still faces many difficulties and challenges as it surveys possible exit strategies from their current policy stances and grapples with the possible medium-term impacts. While the short-term benefits associated with conventional and unconventional monetary policies are self-evident, the costs of the unintended consequences are not. Only time and further policy measures will reveal the magnitude of such costs.
In light of the crisis and the subsequent policy responses, important questions have arisen as to the proper roles, duties, and obligations of central banks in the years ahead.
This report seeks to illuminate central banking lessons from the pre-crisis period, the crisis itself, and the subsequent policy responses, and to add to the important process of delineating central banking roles and responsibilities, and how they have been reinforced and modified. Central banks and their leaderships are continuing a process of self-critical assessment, what should be learned from the crisis, the policy responses, and the outcomes, positive and negative, intended and unintended, that have resulted from those policies.
The report finds that while some of the earlier beliefs held by central bankers need to be modified, there are key pillars that constitute the foundations of central banking that must be maintained. The report identifies three key principles and ten key observations dealing with the Frameworks to Manage and Resolve Crises, and Financial Stability and Crisis Prevention.
The three key principles that are indispensable facets of central banking today and going forward are:
- Longer-term price stability is the most important contribution central banks can make to ensuring strong and sustainable growth. Both high inflation and significant deflation can entail heavy economic costs. Maintaining price stability, frequently understood as a low, stable inflation rate over the medium term, will also contribute to stabilizing business cyclical fluctuations in economic activity through a solid anchoring of inflation expectations.
- Fostering financial stability should also be an important part of a central bank’s mandate. Avoiding excessive credit dynamics is instrumental in achieving this objective, since the accumulation of debt over time can lead to growing imbalances in both the real and financial sectors that can culminate in systemic financial crisis. Central banks should be given responsibility for identifying such systemic threats and for trying to offset related risks to long-term price stability. This implies that central banks must have ultimate authority over all the relevant policy tools, including macroprudential instruments.
- It is crucial that the independence of central banks be maintained. Central banks must be able to focus on policies orientated toward longer-term objectives. They must be kept free from undue political or popular pressures to provide short-term stimulus or other policy actions that are ultimately inconsistent with this core mandate. The indispensable accountability should be ensured without prejudice to the principle of central bank independence.
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