Updated: Aug 10, 2022
What is the role of the central bank? As per the International Monetary Fund, the key role of a Central Bank is to regulate the monetary policy of the nation to achieve price stability and control any economic fluctuations that may occur. Since the 1980s, the leading framework for central banks has become inflation targeting. All their actions are directed with the primary thought: an inflation-less economy means a happy economy, and if the economy is happy, it implies that the central bank must be doing a good job.
However, in the 21st century, we have faced myriad economic crises. We ushered in the century amongst the East Asian Tiger Economic Crises, suffered the blow of the 2007 Global Financial Crisis and entered into the Euro Crisis in 2010 and only when we were all recovering from a global recession induced by these crises, we were hit by the pandemic. In the face of such a turbulent economic climate- has the role of central banks remained static?
A new wave of operational independence
Central banks, in most countries, exist with complete autonomy over their actions and predictions. However, this was not always the case; operational independence for central banks is relatively new. The principle gathered interest in the late 1970s and early 1980s when prominent economists from the ‘rational expectations’ school of thought were awarded the Nobel prize. Their work focused on the implications of people’s ability to look into the future and anticipate the behavior of self-interested politicians.
Self-interested politicians want to extend their incumbency, whatever the means be. Hence, such governments will pump the economy with more and more money to boost the economy and gather the votes of the general public. If discretion over monetary policy is handed over to such individuals, inflation would usually tend to rise. To avoid such situations, it helped to delegate monetary policy to an independent institution. Today, if a politician dares to question and threaten the autonomy of central banks, they lose their credibility.
What Dethroned Inflation as their sole aim?
Now that the way central banks were functioning changed in the 1980s, let’s see if the aims of central banks have changed since then.
At one point in history, the only role of central banks was to regulate prices and conquer the sole enemy, inflation. Regardless of the collateral damage and the multiple other things that would go unnoticed, this was the only goal of the central bank. This idea was so deeply embedded in the functioning of central banks that when someone suggested otherwise, it was considered to be radical (and scandalous, even). During the Jackson Economic Hole Symposium held in 1994, Mr. Alan Blinder, who was a speaker, highlighted how central banks could have more than just one role. He believed that central banks could also assist in tackling the unemployment problem, something that plagued the USA in the 1990s.
While this was considered revolutionary back then, in just a few years, Mr. Binder’s words became the norm for many central banks across the world. This change was a gradual one, not a change inspired by a single event or crisis, suggesting an evolving and dynamic system. Even before the pandemic hit us in early 2020, many economies around the world were losing their enthusiasm for financial stringeness. They came to a realisation that years of budget-cutting had not helped their economy, instead it further plunged the economy into a recession hole that seemed increasingly impossible to climb out of.
While the pandemic definitely helped central cement this realisation that maintaining price stability was not the only and most important aim of the economy, it was a work-in-progress for years before. Central banks understand that the aim of full employment is something they must pursue to ensure society-wide prosperity.
We all know that physical cash has fallen out of favour; the majority of money is digital, created by commercial (albeit regulated) banks. Central banks are being left behind out as commercial banks are carving out a market dominated by them. To continue staying in the money business, central banks are toying with the possibility of issuing digital currencies of their own. A central bank digital currency (CBDC) would extend to everyone, not just limited to commercial banks and their reserves. The public could either hold accounts with the central bank or hold central-bank money in issued wallets. According to the Atlantic Council, a think-tank in Washington DC, 89 countries making up 90% of world GDP are exploring a CBDC.
By stepping into this uncharted territory (for themselves), central banks would be responsible for the intermediation of credit. Public money that was a safer option than commercial bank money now loses that virtue as deposits could easily trickle out of banks just the same. This would also cause the liabilities of central banks to rise, which many are concerned would cause instability to the nation's economy.
Central banks are carving out paths for themselves; whether it is to maintain their autonomy or to remain the main player in the money market. However, policymakers are also adding things to their mandates. On 3rd March 2021, Rishi Sunak (the then-chancellor of the United Kingdom) declared that the bank of England should also conduct policy with an eye towards environmental sustainability. Central banks have been seen as efficient and competent workers, hence more is being put on their plates now. However, one must also remember that they are outside the ambit of democratic accountability. Thus imposing policies like environmental protection further blurs the line between central banking and governing.
As we can see, central banks have had quite the journey in the last century, but we are nowhere near the end. There lies an even more exciting and eventful journey in the future scattered with unseen ideas. Moving forward, we will see the central banks get out of their comfort zone and try to maintain control of the financial systems of their countries while also dealing with the growing digital finance landscape and the evolving demands of the citizens.
(Written by Yasashvi Paarakh and Edited by Prakhar Singhania)