## More focused, less interventionist central banks would likely deliver better outcomes

## Source details

**Canonical URL:** [More focused, less interventionist central banks would likely deliver better outcomes](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/rajan-central-banks-less-more.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/fandd/article/2023/march/rajan-central-banks-less-more.pdf.md)
- [Structured JSON version](/-/media/files/publications/fandd/article/2023/march/rajan-central-banks-less-more.pdf.json)

---

### The case for central bankers
- Pandemic and its economic consequences were unprecedented and hard to predict.
- Fiscal responses were large and harder to forecast because polarized legislatures “could not agree on whom to exclude.”
- Vladimir Putin’s war in February 2022 further disrupted supply chains and sent energy and food prices skyrocketing.
- Central banks were slow to react to growing signs of inflation in part because:
  - They believed they were in the post–2008 financial crisis regime (reference: 2008).
  - The Federal Reserve changed its framework during the pandemic to be “less reactive to anticipated inflation and keep policies more accommodative for longer.”
  - Preemptive rate rises would have lacked public legitimacy given recent fiscal support and recovering employment.
- Even with perfect foresight, central bankers face political and legitimacy constraints when raising rates to slow growth.
- Summary finding: central bank hands were constrained by recent history, adopted frameworks, and political context.

### The case against central banks
- Long periods of low interest rates and high liquidity prompted increases in asset prices and leveraging in both government and private sectors.
- Central bank actions (e.g., quantitative easing) contributed to:
  - Shortening the maturity of government financing by buying government debt financed by overnight reserves.
  - Constraining government finances as interest rates rise, especially for slow-growing countries with significant debt.
  - Potential “fiscal dominance” and “financial dominance.”
- Private sector leverage and “liquidity dependence” emerged because:
  - Commercial banks financed reserves largely with wholesale demand deposits, shortening liability maturity.
  - Banks provided liquidity promises (committed lines of credit, margin support) to generate fees, which are hard to unwind as central banks shrink their balance sheets.
  - Example episode: UK pension turmoil in October 2022, defused by central bank intervention and government backtracking.
- Asymmetric central bank behavior risk: quicker to ease when activity slows or asset prices fall, but more reluctant to raise rates when asset prices bubble.
  - Reference point: Alan Greenspan’s 2002 Jackson Hole speech endorsing mitigation of fallout from asset price booms.
- Consequences of these dynamics:
  - Monetary policy may respond to financial developments rather than inflation.
  - Private sector expectations of earlier cuts can make disinflation harder, requiring harsher policy for longer with worse global activity consequences.
  - Distributional harms when asset prices revert—losses often borne by bureaucrat-managed state pension funds, the unsophisticated, and the relatively poor.
- External spillovers: policies of reserve-country central banks affect periphery countries through capital flows and exchange rate movements, forcing periphery central banks to react even if unsuitable for domestic conditions.

### Mission creep
- Central banks should be free to fight high inflation using familiar tools.
- When inflation is reduced, the world may return to low growth due to:
  - Aging populations.
  - A slowing China.
  - A suspicious, militarizing, de-globalizing world.
- Central bank tools (e.g., quantitative easing) were not particularly effective in enhancing growth and can precipitate fiscal and financial dominance.
- On expanding mandates (climate change, inclusion, inequality):
  - Central banks are not obvious institutions to combat climate change or promote inclusion; often they have no mandate to do so.
  - Central bank tools have limited effectiveness in these areas.
  - New responsibilities could influence effectiveness on primary mandates (example: Fed framework attention to inclusion possibly holding back rate increases).
  - Central banks could follow instructions of elected representatives in some market interventions (e.g., buying green bonds), but this risks external micromanagement.
  - Recommendation: direct actions on climate change or inequality are best left to government; central banks should focus on consequences of these issues for their mandates.

### Choosing frameworks
- Fundamental contradiction: frameworks suited to a low-inflation regime differ from those suited to a high-inflation regime.
  - Low-inflation regime: may require commitment to tolerance of future inflation to raise inflation today (Paul Krugman’s “rationally irresponsible” idea).
  - High-inflation regime: requires strong commitment to eradicate inflation early—“when you stare inflation in the eyeballs, it is too late.”
- Central banks cannot easily shift frameworks across regimes without losing commitment power and credibility.
- Policy recommendation on balance of risks:
  - Reemphasize primary mandate to combat high inflation using standard tools such as interest rate policy.
  - If inflation is too low (but not a deflationary spiral), tolerate it rather than resort to tools like quantitative easing that:
    - Have questionably positive effects on real activity.
    - Distort credit, asset prices, and liquidity.
    - Are hard to exit.
  - Avoid complicating central bank mandates, but consider a stronger mandate to help maintain financial stability because:
    - Financial crises tend to bring on excessively low inflation.
    - Typical remedies for low inflation can fuel asset price booms and leverage.
- Macroprudential regulation:
  - Should be strengthened, especially to cover the nonbank shadow financial system.
  - Evidence to date suggests macroprudential policies have been less than effective (examples: house price booms, crypto, meme stock bubbles).
  - Monetary policy “gets into all the cracks” and thus may need some responsibility for financial stability (quotation: Jeremy Stein).
- External consequences and spillovers:
  - Central banks focused on domestic financial stability will likely adopt policies with fewer spillovers.
  - Recommend dialogue on spillovers beginning at the BIS in Basel and possibly moving to the IMF involving government representatives and more countries.
- Final recommendation:
  - Pending broader political consensus, refocus central banks on the primary mandate of combating high inflation while respecting the secondary mandate of maintaining financial stability.
  - Outcome: more focused, less interventionist central banks would likely deliver better outcomes; “less may indeed be more.”

*RAGHURAM RAJAN is a professor at the University of Chicago’s Booth School of Business and was governor of the Reserve Bank of India from 2013 to 2016.*

---


_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/rajan-central-banks-less-more.pdf_