Until the global financial crisis (GFC) hit in 2008, central banks in the 1990s and early 2000s were lauded for successfully taming inflation and anchoring inflationary expectations in a period now referred to as the “Great Moderation”. Barring the occasional financial turbulence emanating from peripheral economies, central banks by and large had zeroed in on the strategy for preserving price stability through the adoption of narrow inflation-targeting frameworks.
However, the GFC brought about a notable change in central banking playbooks as their focus shifted towards ensuring adequate liquidity in the face of a financial market meltdown. Thus began a prolonged period of ultra-loose and unconventional monetary policy. This policy stance, initially specific to some major advanced economies, expanded to many emerging economies during the COVID-19 crisis as central banks worldwide tried to ensure that the health crisis did not morph into an outright economic depression.
However, as the world enters a post-pandemic era, central banks are confronted with the re-emergence of some old challenges, coupled with a host of brand-new ones, a few of which we outline below.
Return of the inflation bogeyman
The most pressing issue facing central banks in a post-COVID world is the dramatic rise in inflation currently unfolding across both advanced and emerging economies. This spike in inflation has been due to a combination of both supply-side and demand-side factors, including substantial amounts of stimulus rolled out during COVID, pandemic-induced supply chain disruptions, the Russia-Ukraine geopolitical confrontation leading to food and energy price surges, and a general tightening of labour markets.
Even as the official numbers continued to break multi-decade highs, central banks, especially in advanced economies, were culpable in misdiagnosing inflation as being transitory and not responding to these pressures in an adequate or timely manner.
This rising tide of inflation necessitates that central banks go back to the drawing board and refocus their efforts towards containing price pressures and re-anchoring inflationary expectations.
Tackling climate risks
The unpredictable nature of climate change along with its potential to unleash massive capital destruction globally was on display in Europe which suffered relentlessly under prolonged heatwaves and droughts, as well as in the case of the recent floods in Pakistan which has ravaged entire communities and public infrastructure.
The Bank for International Settlements (BIS) has described climate change as a “green swan risk” which has the potential to precipitate the “next systemic financial crisis”. Climate risks could arise both from the financial impact of extreme-weather events and global warming on firms’ balance sheets, called physical risks, and the massive shift/downgrade in asset valuations of high-carbon sectors during the decarbonisation process, referred to as transition risks.
In this context, few central banks have undertaken prudential and regulatory policies to mitigate against the financial stability implications of the transition pathway, such as mandating climate risk disclosures from firms, preparing a taxonomy to clearly delineate between “green” and “brown” activities, and developing new toolkits to better forecast the exposure and impact of climate change both on individual financial institutions and the broader financial system.
Other than the widely documented impact of climate change on financial stability, central banks also need to simultaneously contend with higher inflation attributable to the decarbonisation process in an already-high inflationary environment. This so-called “Greenflation” has arisen due to a surge in demand for inputs required to scale up renewable energy infrastructure such as cobalt, lithium, nickel, and rare earth metals, and increases upside risks to medium-term inflation projections even if other sources of inflation abate over time.
Managing risks and rewards from fintech and Digibanks
The rise of fintech has portended significant benefits for financial inclusion and financial development, facilitating more inclusive growth. The first wave of fintech firms also unleashed massive innovative potential in the banking sector, fostering competition with legacy banks and forcing the incumbents to step up on the delivery of consumer services and products.
The second wave of financial innovation has witnessed the advent of digital banks – operated as standalone digital entities backed either by fintech firms and established brick-and-mortar banks, or large transnational multi-sector conglomerates, colloquially referred to as “Big Techs”.
The multi-nation and multi-sector exposure of these entities raises interconnectedness and the spill over of risks from any one business arm to others, particularly as their business model is built on the leverage and network effects created by operating in several sectors. Further, their transnational nature is also a source of region-wide contagion.
Responding to the rapid rise of crypto assets and DeFi
Central banks have conventionally been regarded as the “guardians of money”, being the sole issuers of currency, i.e., legal tender. However, the recent advent of crypto assets (popularly termed cryptocurrencies) poses new and unique challenges for central banks. While there are thousands of crypto assets currently in the market, a handful such as Bitcoin, Ether, and a host of “stablecoins” constitute much of the aggregate market capitalisation.
Some commentators have highlighted how the rise of private crypto assets could weaken the transmission channels of monetary policy by causing currency substitution away from legal tender. Although the acute volatility of crypto assets including the crash of supposedly “stable” coins – most notably, Terra -- has been a painful lesson to retail investors, their impact on the broader financial system has been limited to date. However, with the rise of exposure to crypto assets by institutional investors and asset managers, crypto markets could become a new source of systemic risk to financial stability, particularly given their increasing synchronisation with other risky assets such as equities.
Another related source of systemic risk is the rise of DeFi (Decentralised Finance) which is a new form of intermediation in crypto markets, likened to a “crypto version of Wall Street” by the New York Times. DeFi is being increasingly harnessed by fintech firms and has raised leverage in crypto transactions by multiple times. The absence of adequate regulation coupled with anonymity in these transactions/activities is of concern on several fronts, including consumer protection, anti-money laundering (AML) measures, and financial integrity, as is the stability of crypto exchanges.
Central banks and regulators are trying to ward off coming crypto storms by bringing them within the regulatory perimeter without stifling innovation in this area of rapid digital transformation.
From Great Moderation to Great Volatility?
Although it would be altogether premature and harsh to proclaim that central banking itself is now in crisis, the Golden age of central banking may have ended, with fears that a period of Great Moderation is now paving the way for a Great Volatility. The global monetary system has become far more complex and turbulent as financial markets have become hyperconnected. Central banks today need to contend with the dual challenge of preventing the entrenchment of higher inflationary pressures while actively identifying and monitoring excessive risks to the financial system arising from new sources.
In addition, central banks in emerging economies in Asia and elsewhere need to maintain vigilance of external financial conditions and US dollar cycles. The stresses emanating from their balance of payments and the pro-cyclical build-up of vulnerabilities and financial imbalances need to be moderated via a judicious combination of foreign exchange intervention and macroprudential tools.
In this period where global-level risks are historically high, the role of central banks will remain paramount. For them to do their jobs effectively, it is important to safeguard their technocratic exceptionalism and keep them insulated from political pressures, though this in turn would require them not to venture beyond their narrow mandates of price and financial stability.