Central banks: Redeeming credibility

The world over, central banks are under attack for not being able to control inflation. Almost all commentators are of the view that they are behind the curve and waited far too long to act.

In the US, the inflation rate has climbed to 9.1 per cent, the highest since 1981. In the UK, it is at a 40-year high of 9.1 per cent. In India, the consumer price index rate for June 2022 was 7.01 per cent.

One would recall that the inflation-targeting mandate of central banks got prominence in the developed countries of the West in the 1970s. The unusually high and persistent inflation prevalent then convinced the governments there that central banks’ priority should be to keep prices stable. Also, to effectively achieve this objective, these institutions should function independently and at arm’s length from politically elected governments. They followed this “mantra” and it worked. Inflation in the West averaged around 2 per cent for almost two decades preceding the 2008 financial crises, down from 7-8 per cent in the 1970s.

As for emerging economies, in many jurisdictions, central banks had in the past behaved more like institutions furthering their governments’ development programmes. Gradually, these jurisdictions too learnt the importance of inflation control and central banks’ independence, and therefore followed the Western model. As a result, many emerging countries successfully adopted the inflation-targeting mandate for their central banks.

Then came the 2008 global financial crisis, which was a result of regulatory failure in the financial sector of the US. It brought in a new set of priorities and challenges for governments and central banks. Issues like financial stability, systemic risk, and the need for intervention to rescue “too big to fail firms” came to the fore.

Financial stability, though a widely used term, is not amenable to being uniquely defined. Maintaining financial stability and containing systemic risk require coordinated action among governments, central banks, and other institutions. While this coordination was a necessity, it resulted in some sort of fuzziness in the division of roles between governments and central banks, and led to central banks acting more as an arm of governments.

The Covid crisis was a result of a medical emergency impacting the real sector economy as compared to the 2008 episode, which was a financial sector failure. Naturally, the action plan to tackle these two crises needs to be quite different. While a monetary stimulus was more relevant in dealing with the 2008 financial sector crisis, it had its own limitations in dealing with the Covid crisis.

However, central banks, while handling the Covid crisis, largely followed the same approach as they did during the 2008 crisis. It would be difficult to say whether they did it on their own or were guided by their governments to do so. Take the example of the US — the Fed went too liberal in buying all types of corporate securities; its balance sheet between March 2020 and June 2021 increased by a whopping $3.8 trillion. This, when there was a clear writing on the wall— at least from the middle of 2021 onwards — that inflation was getting out of control. To a large extent, elsewhere also, central banks kept their monetary policies too loose and for too long a period.

Keeping real interest rates negative for over two years led to reckless and speculative investment behaviour, created asset bubbles, and distorted financial markets. It might have also given birth to Ponzi schemes, which one would come to know in future. Now central banks have suddenly woken up and plan to raise interest rates aggressively and at the same time are hoping for a soft landing of the economy. All this in the name of financial stability and growth!

In general, haziness in the roles of central banks has only increased over time. So they are expected to address structural problems of the economy like tackling inequality, frequently intervene in the functioning of financial markets (a la Greenspan put), and indulge in commercial operations.

Central banks seem to have forgotten that there is one role, viz. controlling inflation, which is solely their responsibility and which they should be performing independently and at arm’s length from the government. All this is in some way means unlearning the lessons of the 1970s.

The interest rate is a blunt tool with central banks. Many of the objectives that they were presumably trying to achieve through monetary policy during the Covid pandemic should have been best left to their governments. Monetary policy cannot be a substitute for fiscal policy.

Central banks need to focus on their mandate to control inflation, which is their “dharma”. They should resist taking on additional functions, which may be conflicting or may take away their time and attention from the main job. It is the need of the hour for central banks to regain their credibility.

The writer, who was in the Indian Administrative Service, is former chairman, Securities and Exchange Board of India