Warwick Business School
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Warwick Business School
Five Challenges for Central Banking
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Warwick Business School
wbs.ac.uk
Introduction
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Controlling inflation
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Financial stability
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Payments and digital currencies
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Sustainability and central bank independence
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A changing financial system
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Final thoughts
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Warwick Business School
wbs.ac.uk
Introduction Modern central banks have broad responsibilities to ensure monetary and financial stability. In consequence they have a huge, sometimes dominant impact on financial markets which in turn affects the lives of every citizen. The policy and operational issues arising are explored in detail in the Warwick Business School Global Central Banking & Financial Regulation qualifications , which I contribute to. In this document, we consider five current challenges to central banking which reflect just some of the subject matter of the course. What it illustrates is that central banking is continually evolving to face new challenges as they arise – challenges which are both complex and pervasive! To follow policy development one needs to understand, not just what is being done, but the frameworks within which central banks work and think.
Paul is a British economist who worked for the Bank of England for 26 years, holding senior positions including Executive Director for Markets and Deputy Head of the Prudential Regulation Authority (PRA). He was a member of the Monetary Policy Committee, the Financial Policy Committee and the PRA Board. He now has a portfolio of roles, including as an Advisor to the Bank’s Centre for Central Banking Studies.
Paul Fisher Former Executive Director, Bank of England, and Honorary Professor, Warwick Business School
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Warwick Business School
wbs.ac.uk
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Controlling inflation
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Controlling inflation
Warwick Business School
wbs.ac.uk
The fundamental objective for all central banks is to preserve the value of their currency. High and variable price inflation is a bad outcome for society. A lesson that we have all been personally re-learning over the past few years.
Inflation distorts relative prices and rates of return, and that interferes with economic decision making, leading the economy to run much less efficiently. It acts like a tax on holding cash – badly affecting the poorest people who tend to have fixed, low incomes whilst fixed nominal tax thresholds amplify that effect for those on regular wages. Of course, higher taxes improve the government’s financial position, but this is seldom popular!
We know that inflation can be contained by making a long-term commitment to stable prices, using interest rates as the instrument of control, albeit there are long and variable lags. Governments found that they could exploit the lags by cutting interest rates just before an election (for example), with the inflationary costs not arising until sometime later.
One of the major achievements of academic macroeconomics has been the theory and evidence which concluded that the best way to avoid such abuse was to delegate monetary policy to an independent central bank, with an explicit inflation objective. Inflation targeting or similar regimes have since been implemented in most large, developed economies and many smaller or less developed nations, with outstanding results. Until recently that is!
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Controlling inflation
Warwick Business School
wbs.ac.uk
In 2022, inflation soared to 9% pa in the US and over 10% in the UK and the Eurozone. In many other countries it went even higher in the worst global inflationary episode since inflation targeting began in the early 1990s. Central banks need to learn from this experience. What went wrong – was it all to do with a severe rise in energy prices after the unexpected Russian invasion of Ukraine? Or did it have its roots much earlier in the fiscal and monetary support offered to the real economy during the pandemic? In other words, was it due mainly to a supply shock or a demand shock? Either way, why was the inflation not anticipated and why is it taking so long to bring inflation back to target? Was this just the result of a series of unprecedented events that won’t re-occur? Or does something need to change in the policy framework? If these questions can’t be answered, with the help of the wider economics community, then the independence and authority of central banks will be brought into question.
In 2022, inflation soared to 9% pa in the US and over 10% in the UK and the Eurozone.”
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Warwick Business School
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Financial stability
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Financial stability
Warwick Business School
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Financial stability is something that most of us take for granted – until we don’t have it!
Financial instability is bad for the economy as a whole, but if your bank is in distress and you can’t access your money, or if the payment system stops working and you are sitting in a car park unable to access your new house because the money hasn’t gone through, it can can also create personal stress directly. One of the consequences of raising interest rates sharply to control inflation, has been increased pressure on the financial system. In a spectacular failure of risk management, several US banks went bust in March 2023, having made losses on longer-term bonds whose value varies inversely with interest rates. For unrelated reasons, but at the same time, Credit Suisse - one of the largest international banks in the world - also failed. In both cases the response of the authorities was not as expected.
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Financial stability
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The US extended their (industry-funded) deposit guarantee scheme to cover all depositors. And the Swiss authorities did not follow the long-planned international resolution framework for systemically important banks, which was ready to be deployed. Instead, and at the last minute, they organised an emergency rescue by UBS, backstopped by state guarantees. In the US, Silicon Valley Bank (SVB) had a large deposit base from tech firms most of which exceeded their insured deposit limits. The unprecedently large and quick run on the bank was amplified by social media and internet banking. But how did they fail so badly without the US bank supervisors spotting the risks and intervening earlier? Why did the US not follow their pre-set deposit insurance limits?
These episodes have already been the subject of international reports and may well result in changes in future crisis planning. But the challenge is that if the authorities don’t follow their own emergency plans, then markets don’t know how to price in the risks. The financial system will be less effective and less resilient. Credibility of financial policy is hard to win and easy to lose.
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Payments and digital currencies
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Payments and digital currencies
Warwick Business School
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People are using cash less to pay for what they buy. Does this matter? It does to those who have no bank account, or access to other, electronic payment forms. And it matters to central banks responsible for the resilience of the payments system and the transmission mechanism for monetary policy. Private digital ‘currencies’ do not share all the attributes associated with a true currency – store of value, unit of account and a medium of exchange. They have, however, grown in popularity, could displace at least some functions of other currencies, and can exist outside of the banking system. Traditional forms of finance may be under threat. One option to respond is by extensive regulation of private digital currencies – so far largely avoided. Another would be for central banks to introduce their own.
To date, four countries use central bank digital currencies (CBDCs) and many others are running pilots. Around 120 are at least researching the possibility. It is probably just a matter of time before we are all using them but many operational questions about their optimal design and use are still being debated, including questions over whether they will increase the risk of bank runs, and privacy concerns over their substitution for cash.
Learn more about the transformative impact of emerging technologies on financial activities from experts at the Gillmore Centre for Financial Technology
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Sustainability and central bank independence
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Sustainability and central bank independence
Warwick Business School
wbs.ac.uk
Climate change is an existential threat to the human race that has risen high up the political and social agenda. We are all directly affected, and we are all partly responsible.
No central bank is the lead authority on making its economy sustainable – that responsibility lies properly and everywhere with governments who have control over the necessary legislation and fiscal policy to address the issues. But to meet their existing statutory objectives, central banks need to take account of any potential shocks to the macroeconomy in general and the financial system in particular. Climate shocks threaten the economy and hence monetary policy must take them into account. Climate shocks also pose risks to the banking system and hence financial regulation and policy must respond to try and make the system resilient.
Similar issues arise with other sustainability issues such as biodiversity and natural capital loss. Nevertheless, the involvement of central banks in sustainability issues has raised questions of over-reach – especially in countries where these are politically sensitive topics. Central bank independence is a double-edged sword: Being independent does not mean that one’s actions are unconstrained. Central banks will be keen to be seen to strike a balance between addressing these major risks within their mandates, whilst not taking on responsibilities which they have not been formally given.
Climate shocks threaten the economy and hence monetary policy must take them into account.”
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A changing financial system
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A changing financial system
Warwick Business School
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Sometimes one has to run fast just to stand still. The financial system is continually evolving as we all change our habits. Central banking has to evolve to reflect changes in people’s behaviours, in particular how that impacts on financial markets. Over the past 15 years, and in the face of low inflationary pressures and interest rates close to, or even below, zero, many developed country central banks have loosened monetary policy through expansion of their balance sheets. Now they face the prospect of reversing that expansion.
But no one knows what an optimal balance sheet looks like for a central bank: How big should the balance sheet be? What assets should be held? Who should be entitled to bank with or borrow from the central bank? If transactions move outside the banking system – to capital markets and shadow banks - how can financial stability best be maintained? How should the authorities respond to financial failures? These and many other questions are challenging the concept of what a central bank is, what its responsibilities are, and how it operates each in its own domestic economic and political environment. One thing is certain – the actions of central banks have an increasingly important and sometimes dominant influence on the financial system and hence the wider economy on which we all depend.
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Final thoughts
Warwick Business School
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Final thoughts As these examples show, to be involved in central banking and financial regulation is to be at the cutting edge of how society is transforming itself and how the authorities should respond. Whilst there are many similarities across countries, each central bank pursues its objectives in a unique fashion, consistent with local economic and political imperatives. Comparisons and contrasts across countries are the subject of the module Comparative Central Banking module , one of the many Global Central Banking and Financial Regulation qualifications at Warwick Business School.
Students are posed the question ‘why do central banks (and other financial regulators) do things differently?’. Answering that question creates the best understanding for why central banks do what they do at all. Whether you are a central banker, regulator, or working in financial services, it represents a ‘crash course’ in everything you should know about how these authorities operate across all their facets.
Why do central banks and other financial regulators do things differently?”
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Warwick Business School Global Central Banking & Financial Regulation qualifications Designed for professionals working in the banking and financial sectors who require a level of flexibility in order to develop their career alongside other commitments. Delivered by academics from Warwick Business School alongside policy experts from the Bank of England, and beyond, these qualifications will introduce you to the latest evidence-led and practice-informed financial regulation and monetary policy, while providing practical discussion of real-world cases.
Visit our Global Banking webpage
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Our modules cover a range of valuable topics including:
Monetary Policy & Monetary Analysis Financial Regulation & Supervision Comparative Central Banking Behavioural Finance Financial Conduct, Leadership & Ethics Money, Banks & Macroeconomics Financial Markets & Financial Risk Management Big Data
Key information Taught entirely online part-time Four qualification levels Choice of three start dates
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