Less Is More

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Less Is More

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Bibliographic details

• Authors: RAGHURAM RAJAN
• Published: March 1, 2023

Thesis and overview

• More focused, less interventionist central banks would likely deliver better outcomes.
• Central banks should refocus on their primary mandate of combating high inflation while respecting a secondary mandate of maintaining financial stability.

Case for central bankers

• Pandemic and unexpected shocks:
  • The pandemic was unprecedented and its consequences for the globalized economy very hard to predict.
  • Vladimir Putin went to war in February 2022, disrupting supply chains and sending energy and food prices skyrocketing.
• Frameworks and beliefs constrained action:
  • The Federal Reserve changed its framework during the pandemic to be less reactive to anticipated inflation and keep policies more accommodative for longer.
  • That framework was appropriate for an era of structurally low demand and weak inflation but was ill-suited as inflation began to rise.
• Political legitimacy limitations:
  • With governments having spent trillions to support economies, employment recovering from terrible lows, and inflation barely noticeable for over a decade, preemptive rate rises lacked public legitimacy.
• Summary point:
  • Central bank hands were tied by recent history, adopted frameworks that favored accommodation, and the politics of the moment.

Case against central banks

• Fiscal and financial dominance emerged:
  • Long periods of low interest rates and high liquidity prompted increases in asset prices and leveraging across government and private sectors.
  • Central banks bought government debt financed by overnight reserves, shortening the maturity of financing for governments and central banks’ consolidated balance sheets.
  • Fiscal considerations already weigh on some central banks (example: the European Central Bank and concerns about “fragmentation”).
• Private sector leverage and liquidity dependence:
  • Commercial banks financed reserves largely with wholesale demand deposits, shortening the maturity of their liabilities.
  • Banks wrote liquidity promises (committed lines of credit, margin support) that are hard to unwind as central banks shrink balance sheets.
  • UK pension turmoil in October 2022 illustrated liquidity-dependent private sector dynamics, defused by central bank intervention and government backtracking.
• Asymmetric central bank action and distributional costs:
  • Central banks may be quicker to ease policy when asset prices fall but more reluctant to tighten when asset prices bubble, following a long-standing asymmetry.
  • High asset prices and subsequent losses when prices normalize can harm households, pension funds, and the relatively poor.
• External spillovers:
  • Policies of core reserve countries affect the periphery via capital flows and exchange rates, forcing periphery central banks to react even if actions are unsuitable domestically.
• Summary point:
  • Central banks’ past unconventional and asymmetric policies contributed to imbalances that constrained their ability to fight the higher-inflation regime.

Mission creep and mandates

• Limits of expanding central bank roles:
  • Central banks are not the obvious institutions to combat climate change or promote inclusion; often they have no mandate to do so.
  • Central bank tools have limited effectiveness in areas like climate change or inequality and may influence effectiveness on primary mandates (example: inclusion focus potentially holding back rate increases).
  • Directly combating climate change or inequality is best left to elected governments.
• Regime-dependent framework contradiction:
  • Low-inflation regime: may require commitment to being more tolerant of inflation to raise inflation (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.”
  • A framework that credibly commits in one regime may undermine commitment in the other; central banks cannot easily shift frameworks without losing commitment power.

Choosing frameworks and financial stability

• Recommended emphasis:
  • Reemphasize the mandate to combat high inflation using standard tools such as interest rate policy.
  • If inflation is too low, tolerate it unless it collapses into a deflationary spiral; avoid tools like quantitative easing that distort credit, asset prices, and liquidity and are hard to exit.
• Financial stability role:
  • Central banks may need a stronger mandate to help maintain financial stability because prolonged low inflation episodes can follow financial crises and monetary tools contribute to asset-price-driven leverage.
  • Macroprudential supervision remains important but has been insufficient so far; better coverage of the nonbank shadow financial system is needed.
  • Monetary policy “gets into all the cracks” and with that power should come some responsibility.
• External dialogue on spillovers:
  • A dialogue on spillovers should begin at the BIS in Basel and then involve the IMF and government representatives to discuss central bank mandate changes in an integrated world.
• Summary point:
  • Refocusing central banks on combating high inflation and maintaining financial stability will likely produce fewer spillovers and better outcomes.

Policy recommendations and concluding assessment

• Principal recommendations:
  • Refocus central banks on primary mandate of combating high inflation.
  • Respect secondary mandate of maintaining financial stability, including better macroprudential coverage of the financial system and attention to the nonbank shadow sector.
  • Avoid expanding mandates into climate change and inequality; leave direct action to elected governments while assessing implications of these issues for monetary and financial stability objectives.
  • Promote apolitical international dialogue (BIS, then IMF) on spillovers and possible mandate adjustments.
• Final assessment:
  • More focused and less interventionist central banks would probably deliver better outcomes than the high-inflation, high-leverage, low-growth world described.
  • For central banks, less may indeed be more.

Raghuram Rajan, "For Central Banks, Less Is More", F&D Magazine, March 2023.

Content in this bundle

• F&D March 2023: Central Banks; Less is More
  • F&D March 2023: Central Banks; Less is More (Markdown version)
  • F&D March 2023: Central Banks; Less is More (PDF)