Policy evolution: Despite challenges, central banks must keep adapting

“I guess I should warn you. If I turn out to be particularly clear, you’ve probably misunderstood what I said,” former Federal Reserve chairman Alan Greenspan famously remarked in 1988. A lot has changed since then in the world of central banking. No senior official of any large central bank wants to be even remotely misunderstood by financial markets. In fact, they go to great lengths to ensure clarity, and policy decisions are carefully telegraphed. Communication has become an important tool, which is used, particularly by large central banks, to shape expectations and prepare markets to absorb policy decisions with minimal disruption. The evaluation of central banking in recent decades and possible future challenges were covered by Reserve Bank of India (RBI) Governor Shaktikanta Das in an interesting speech in Kathmandu this week. A broader discussion on some aspects would help improve policy clarity.

Central banks have faced significant challenges in recent decades. Most large central banks have been grappling with high inflation rates over the past couple of years after having misjudged the early warning signs. These conditions were vastly different compared to the global financial crisis (GFC). Central banks were then trying to avoid deflationary conditions after hitting the zero lower bound. Some opted for negative interest rates and others went for heavy doses of quantitative easing to normalise the real economy. Not too long ago some of these tools were only debated theoretically. Although the nature of the crisis was different, the post-GFC playbook came in handy during the pandemic. The position of emerging market central banks has been more complex. They have also had to deal with the significant spillover effects of policies in advanced economies for extended periods. After suffering during the taper tantrum episode of 2013, policymakers in India focused on strengthening macroeconomic stability, which has helped India deal with global spillovers in recent years.

Mr Das also highlighted important aspects of the future challenges. For instance, climate change can increase policy complications. It can increase risks for both price and financial stability. In the Indian context, where food is a relatively big component of the consumption basket, climate shocks can push up headline inflation rates for extended periods and policy response can lead to significant growth sacrifice. Sustained geopolitical tensions can also pose serious challenges with disruption in supply chains and capital flows. Another aspect is the evolution of technology. Technology has changed the face of banking and finance in recent years and has helped improve financial inclusion. However, it also poses a new set of challenges. Banking, for example, is an inherently risky business and runs on trust. Any erosion of trust can result in deposits moving out far more quickly as seen during the mini banking crisis last year in the US. Given the interconnectedness of the financial system, any financial institution of significant size can pose systemic risk.

It is thus important that all regulated financial entities are in good shape at all times. To its credit, the RBI over time has taken prudential measures to contain vulnerabilities in the banking and financial system. Although there have been instances of misjudgement, central banks worldwide have evolved substantially over the decades, having developed new tools in their efforts to maintain price and financial stability, which are critical for maximising output. This evolution must continue to address both “known unknowns” and “unknown unknowns”.