Central banking… what’s the future?

January 26, 2012

The Federal Reserve has taken a historic step of adopting an explicit inflation target of 2 percent at its two-day meeting ended on Wednesday, highlighting how central banks must adapt to the new post-crisis world.

In a new book “The Future of Central Banking”, Claudio Borio, deputy head of monetary and economic department and director of research and statistics at the Bank for International Settlements, argues that the financial turmoil has shaken the foundations of the deceptively comfortable central banking world.

”Pre-crisis, the quintessential task of central banks was seen as quite straightforward: keep inflation within a tight range through control of a short-term interest rate and everything else will take care of itself. Post-crisis, many certainties have gone. Price stability has proven no guarantee against major financial and macroeconomic instability,” write Borio, who is also a director of research and statistics at the BIS.

Borio proposes a set of three new guidelines for central banking in the future.

  1. Adjust current policy frameworks: Beyond letting central banks play a leading role in establishing fully fledged macroprudential frameworks, authorities must adopt monetary policy strategies that allow them to tighten to prevent the build-up of financial imbalances even if near-term inflation remains subdued.
    “Operationally, this calls for extending the policy horizons beyond the roughly two-year ones typical of inflation targeting regimes.”
  2. Reconsider monetary policy responses to the busts: Monetary policy should pull out all the stops to prevent the implosion of the system as the crisis erupts. But, thereafter, the priority should be to repair balance sheets and facilitate the necessary adjustments in the real economy.
  3. Strengthen operational independence of central banks: In crisis prevention, the autonomy of those in charge of macroprudential decisions is critical. “The political economy pressures not to take away the punchbowl when the party gets going are well known in the context of inflation, but they are even stronger when financial booms are underway.”
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