Tuesday, May 26, 2009

Changing face of Central Banking

I had blogged earlier about how Central bankers across the world had come to believe that they had to merely to calibrate their interest-rate tools (the short term, overnight, money market rate, whose changes in turn got transmitted across the interest rate chain) to keep a lid on inflation, thereby ensure financial stability and full employment, and smooth over the business cycle. However, as the sub-prime mortgage crisis showed, this "inflation targetting" approach failed to prevent the build-up of imbalances that presaged the crisis and was insufficient in dealing with failing banks and financial-market stress as the crisis developed.

The Economist points out has a nice summary of the changing role of Central Banks. A few od the observations here

1. Central Banks, led by the Federal Reserve, have turned from being lenders of last resort to "become lenders of first resort when banks stopped trusting each other. They are, increasingly, arbiters of which types of borrowers get credit. With the reputation of market discipline in tatters, central bankers will get vast new supervisory powers. All this is dragging central banks back towards political turf from which they had been distancing themselves for years."

2. Now, with recession deepening, interest rates touching the zero-bound, credit markets frozen up, and deflation taking hold, Central Banks have run out of conventional monetary policy options. Deflation and not inflation is the main enemy. The global savings glut and credit squeeze broke the link between short and long-term interest rates. The Central Banks have resorted to a number of unconventional responses, "expanding their lending operations through a mixture of more types of credit and collateral, longer terms and more counterparties", as outlined below.

3. Central Bankers embrace of macro-prudential regulation to prevent the build-up of endogenous systemic risks is a reversal of their hitherto held position "to shed supervisory duties and concentrate on monetary policy". Supervision was seens as a "distraction from the pursuit of price stability and created potential conflicts - a central bank might run an inflationary policy to cushion a failing banking system, or prop up an insolvent bank to cushion the economy".

1 comment:

Amol Agrawal said...

I think Dr YV Reddy, former RBI Governor sums it up the best(Hindu Business Line, 11 October 2008):

An outcome of the crisis, according to Dr Reddy, is the “historically significant redefining of the concept of the central bank”.