New Doctrines in Central Banking
Background Conditions: Inexorable Decline of the « Natural » Rate of Interest
The Covid-19 pandemic has put the spotlight on the key role of central banks in crisis management. Central banks have again demonstrated their ability to deal with systemic events by adapting their response. Central banks in advanced and emerging economies implemented an unprecedented set of measures, going far beyond those adopted during the financial crisis. These measures were aimed not only at stabilizing financial markets, but also at channeling credit directly to businesses and households. The difficulties and challenges are many and range from the emergence of new financial markets to better coordination of fiscal and monetary policies.
There is a consensus that self-insurance through the accumulation of foreign exchange reserves is not optimal. Similarly, there is little that countries can do to limit risk through protective measures in managing capital flows without forgoing the benefits of participation in the global financial system. In the absence of a comprehensive and well-funded global safety net, liquidity safeguards under the aegis of the central bank issuing the international currency will remain the primary protection (Carstens, 2021b).
The best way to reduce the tension between fiscal and monetary policies is to increase sustainable growth. Achieving higher growth requires structural reforms, supported by growth-friendly fiscal policies. The independence of central banks is essential so that they can continue to focus on their core mandate of maintaining price and financial stability.
Short-term rates have been negative in the eurozone since 2014. This paper demonstrates that the central bank has been constrained in its responses to a disinflationary environment after the financial crisis. The ECB's new strategy, adopted in July 2021, emphasizes a disinflation control objective. Will interest rates, which are in fact directed by the ECB, be able to evolve naturally at a level consistent with potential growth and the inflation target of around 2%?
The uncertainty about growth, the return of inflation and the need for an energy transition are renewing the economic policy debate. If the situation was previously referred to as secular stagnation, other names are emerging: stagflation reflation. Beyond the diagnosis, what use should be made of monetary or fiscal policy in an environment of high debt? This issue is all the more important as the European rules of budgetary coordination are being questioned. Based on concrete examples, this article asserts the central role of fiscal policy in relation to monetary policy. This development should be understood as a rehabilitation of “functional finance” in a measured form. The implications for the mandate of central banks and the European fiscal framework are developed.
The Need for New Doctrines, New Monetary Strategies
This article outlines the main features of the new monetary policy strategy of the European Central Bank (ECB). Under this strategy, the ECB is focused on stabilising inflation at 2% over the medium term. It takes a symmetric perspective on deviations from this target: overshoots and shortfalls are viewed as equally undesirable. At the same time, the strategy fully takes into account the implications of the effective lower bound: since there is an effective floor to policy rates, it is strategically necessary to also deploy interest rate forward guidance, asset purchases and targeted long-term refinancing operations to ensure that the inflation target is achieved. The new strategy also seeks to incorporate the implications of climate change and the carbon transition for macroeconomic and inflation developments.
This paper argues the ability of the new monetary policy frameworks established by the US Federal Reserve in 2019 and 2020 are adapted by the dynamic steering of inflation to the current challenges of an inflation recovery. These changes, which aimed at giving long-run objectives to monetary policy, have indeed major political implications.
Central bank policy has helped to overcome two major crises in the recent period. And if the adage that central banks cannot do everything remains true, it is nevertheless clear that central banks are now obliged to take an interest not only in the monetary pillar, but also in new categories such as the rise in public debts, the investments needed for climate change, the rise in inequality or the concentration of wealth, in short to broaden the criteria for stability through a monetary and financial analysis.
When assessing the question whether new doctrines, guidelines for monetary policy should be considered the experience of the past, mistakes or successes has to be analysed. For example – what have we learned from the period of the “great moderation” in which an improved monetary policy played a major role? The Fed and the European Central Bank (ECB) have reviewed their strategies. Both central banks have changed their inflation target. Inflation targeting as such is widely seen as the optimal strategy. However, no model of inflation targeting exists so far that integrates the risks from the banking system and financial markets with all their dynamics, non-linearities and overall complexity. The “second pillar” of the ECB's strategy can be seen as an approach to integrate these aspects into the process monetary policy decisions.
Controlling or more modestly guiding inflation expectations remains a major challenge for central banks. Forward guidance has become the main communication strategy to anchor inflation expectations. However, theory and practice have revealed severe problems of this approach.The expanding role of central banks has raised concerns about the independence of this institution. Overall, the role of central banks in society has to be reconsidered. Central bankers should not ignore the threat to their independence by involving themselves in political issues.
The effectiveness of central banks to fulfil their policy goals depends also on their ability to clearly signal their intentions to financial market participants and the general public. After all, monetary policy actions are transmitted via financial markets to the real economy and private households. In normal times, that is before the financial crisis, the short-term interest rate was the main tool to communicate the policy stance. Knowing where the short-term interest rate would go, would provide a good guide to where the central bank wants the economy to go. The addition of unconventional policy tools, such as outright purchases of financial assets, and a closer interaction between monetary and fiscal policy has made “reading” central banks more complicated for market participants. This in turn makes a stronger effort from central banks necessary to get their message across. Unfortunately, it also implies a higher risk of mis-communication and policy mistakes.
Too Close to Justify? Fiscalization of Monetary Policy
Since 2007, and especially during the Covid pandemic, central banks have expanded both the scope and scale of their interventions in unprecedented fashion, blurring the lines between monetary and fiscal policy. This fiscalisation endangers central bank independence, thereby weakening monetary policymakers' ability to deliver on their mandates for price and financial stability. To find a way back to the pre-2008 division of responsibilities, governments must establish clearer limits on what central banks can and cannot do. To limit fiscalisation, authorities can do two things: commit to structural distinctions between fiscal and monetary policy, and articulate a balance sheet reaction function (analogous to a policy interest rate reaction function) that includes the reversal of crisis interventions when market functionality is restored. Having engaged in fiscalisation more than once, either by choice or by circumstance, central banks need to establish a framework that prevents repetition.
Comparing and contrasting the Fed's and ECB's policy responses to the 2008 global financial crisis (GFC) and the Covid-19 pandemic highlights the importance of the fiscal dimension of monetary policy and the potential pitfalls when the synergy of fiscal and monetary policy is neglected by an independent central bank. For the ECB, two critical changes in its policy response led to notably better outcomes in the aftermath of the pandemic. In contrast to the hesitation it exhibited in 2008, the ECB expanded its balance sheet more appropriately in 2020 with decisive purchases of long-term government debt. Furthermore, the ECB suspended elements of its policy framework that had impaired the functioning of government debt markets, such as the reliance on credit rating agencies for determining the eligibility of government debt for monetary operations. By protecting government bond markets from the self-fulfilling adverse equilibria that the ECB had tolerated in the aftermath of the GFC, the ECB supported refinancing government debt at low cost in the entire euro area, instead of only in selected Member States. This facilitated more expansionary fiscal policy that supported a more robust recovery, and protected against the further fragmentation of the euro area.
Widening Horizon: Additional Challenges
Greenhouse gas emissions do not cost anything to their emitters, so climate change is a good example of an externality: in their individual choices, economic agents do not sufficiently take into account the damage that their choices cause to the environment.
The Paris Agreement was a giant step forward, but it must be followed by rapid collective action. The transition to carbon neutrality requires a global effort from all sectors. This includes the finance industry, whose central role was first highlighted in Article 2.1c of the Paris Agreement, which calls for “financial flows consistent with a pathway to low greenhouse gas emission and climate resilient development” (UNFCCC, 2015). In other words, the financial system must play a key role in supporting economic transformation.
Climate change has implications for the missions and operations of central banks. Moreover, while the topic of climate change is relatively new to central banks, it is nevertheless a concept deeply rooted in their traditional mandates and therefore does not constitute a new doctrine or require its invention. Rather, it is a modern and timely interpretation of central banks' long-standing objectives, which primarily require them to preserve price stability and sometimes also to facilitate sustained growth, promote employment or preserve financial stability.
The Asymmetric Relationship of Central Banks to Market-Based Finance: Weighing Financial Stability Implications in the Light of Covid Events
Central banks today operate as the backstop of a fragile and volatile market-based financial system, as evidenced by the recent financial instability in the context of the Covid-crisis. This article investigates the genesis of this position, tracing it to an asymmetric program by central banks to prevent financial instability. Quick and resolute in moments of crises, this program is slow and hesitant, if not ineffective in moments of financial booms. This state of affairs is linked to the lacking control of central banks over the pro-cyclical behavior of non-bank financial institutions in the shadow banking sector, outcome of a fragmented system of governance which central banks share with market authorities. The Covid crisis and the subsequent large scale quantitative easing programs, undertaken to ensure the stability of this system of credit-intermediation, clarify the need for a fundamental re-regulation of this sector. If central banks are to continue to backstop this sector, as it looks likely to be the case, they need to request a substantial expansion of regulatory oversight and control. Absent such reforms, the de facto backstop will install moral hazard, inviting increased risk-taking in the sector.
The Sovereignty of Money and its Historical Transformations: the Invention of Central Bank Digital Money in the 21st Century and its Geopolitical Consequences
The emergence of digital technologies threatens the sovereignty of money by opening up payment systems to non-bank players, the Bigtechs. These derive enormous rents from their monopolization of e-commerce platforms, including through the capture of consumer data. In the absence of any regulation, they exercise unfair competition vis-à-vis banks. Facebook's Libra project – now seemingly being sold - , purporting to establish a global currency under the control of a private monopoly, has caught the attention of monetary authorities and financial regulators. Apart from establishing regulations to restore competition in payment services, the assertion of monetary sovereignty within nations is leading to the emergence of central bank digital currency. This innovation appears at different speeds depending on the country. It comes in parallel to the disappearance of cash. In many countries by now, including China, provisions are made in the organization of payments to avoid destabilizing commercial banks.
The thorniest problem concerns the transformation of the international monetary system (IMS). Not a detail, the digital code that identifies central bank digital currency allows them to retain control of the cross-border use of the cash they issue. This fundamentally calls into question the principle of “dominant currency”. A reform of the IMS will have to follow with two possibilities: an accounting of the digital codes to establish a global synthetic currency or, more likely, the promotion of the digital SDR as the ultimate liquidity. This would, at last, establish monetary multilateralism by making the IMF the international lender of last resort.
The societal responsibility of central banks echoes the social responsibility of companies. The difference in the term reflects the fact that central banks are responsible to society as a whole and not simply to the partners with whom they have contractual relations. In this article, we seek to decipher the forces at work in the deconstruction of the myth of a central bank solely dedicated to preserving the value of money and disconnected from major societal issues and debates. We develop the idea that since the financial crisis, central banks have been re-engaging their politics in the life of the city. We illustrate this assertion through two intensely debated questions: on the one hand, the effects of monetary policy in terms of inequality and, on the other hand, the role of central banks in the ecological transition. Finally, we point out some unresolved issues regarding the social responsibility of central banks.
The European Central Bank: What Accountability to the European Parliament, Corollary of its Independence in Order to Assure its Credibility and its Legitimacy?
The development of monetary policy and the role of the ECB after 2007 reopen the debate on the conditions and modalities of its democratic accountability to the European Parliament. It was built from 1998 on the basis of the Maastricht Treaty; it has evolved in parallel with the institutional development of the ECB's responsibilities, but the rise of unconventional monetary policy, its side effects and the broadening of the interpretation of its mandate raise new questions.
Financial History Chronicle
Does the Evolution of Prudential Standards Affect the Risk of Non-Compliance Banks in CEMAC Countries?
In this article, we empirically analyze the evolution of prudential ratio from Basel I to Basel III and assess its effect on the level risk of non-compliance banks in CEMAC countries. To achieve this, we specify and estimate, with resort the method of simultaneous equations, over the period 2000-2018, several variants of the reaction function of commercial banks in dynamic panel on a sample of 6 countries of CEMAC region. Our results show, firstly, that the drop in the intermediation margin leads banks to select the least risky projects in order to comply with prudential standards; and, second, that a change in the level of risk constrains banks to adjust their level of competition through an informational advantage over borrowers. In addition, the procyclicality of prudential regulation is amplified while the risk of non-compliance is weakened.