Challenges for central banks

Speech by Mr Agustín Carstens, General Manager of the BIS, Institute of International Finance (IIF) Board meeting, 17 January 2022.

Thank you, Tim and Axel, for another opportunity to participate in an IIF Board meeting.

In the context of the pandemic, the actions of central banks, together with fiscal support and supervisory flexibility, have ushered the global economy into a strong, fast recovery. This was no mean feat. Decisions had to be taken under much uncertainty and they involved difficult trade-offs. What comes next will be a treacherous path to navigate, and a lot depends on how central banks respond. In addition to an exacting macroeconomic environment, digitalisation is changing the structure of the financial and monetary system and demanding central banks' attention.  So, I would like to devote my remarks to highlighting the main challenges that central banks will face in the next few years.

How we got here

When Covid-19 hit two years ago, we found ourselves in uncharted waters. The pandemic was a truly exogenous shock: a recession ensued from the drastic public health measures that were required.

Information about the virus and its impact on the economy became available only as time passed, and it was and continues to be imperfect. Acting under this uncertainty, the policy responses were fast and bold, taking some calculated risks. Policymakers recognised that, after the economy had been deliberately put into a coma, it would need all the life support it could get in order to avoid bankruptcies, worker displacement and scarring.

They were under no illusions: such measures would come at the cost of higher public debt, to say nothing of potential financial distortions and allocative inefficiency. But their thinking was, and in my view rightly so, that any inaction on their part would have led to far worse outcomes.   

So, central banks deployed their full arsenal of tools. They tailored their response to the nature of stress experienced in each country and the structure of their financial systems. They promptly eased their policy stance, acting decisively to prevent market dysfunction. This was complemented with supervisory flexibility, to support banks' ability and willingness to lend. The fiscal policy response too was swift and forceful.

A unique and rapid rebound has followed the recession. A much-feared wave of defaults and bankruptcies did not materialise. The unprecedented degree of support for corporates implied a massive decline in bankruptcies in spite of the recession. And, not least thanks to the strong policy response, private demand bounced back faster than in previous global recessions, in particular with strong demand for goods.

But the faster recovery has come with some surprises: it has unleashed inflation, which in most advanced economies had been all but absent for nearly a decade. Deciphering the drivers of that inflation has been challenging. The pandemic shifted demand away from services towards goods. Adjustments in supply have been difficult. Supply constraints and bottlenecks, which became prominent in 2021, are likely to stay through at least mid-2022.

In some economies, signs of labour shortages have also appeared, attributable to an increase in reservation wages, falling participation rates and skill mismatches. Covid-hit workers in the logistics chain and clogged delivery pipelines.

Overall though, the bottlenecks seem to relate more to the suddenness of the demand recovery, which came up against inelastic short-run supply, amplified by bullwhip effects.

What is next?

Central banks need to assess how robust the recovery is and urgently address inflation – while managing the effects of Omicron and any yet-to-emerge Covid variants.

The shape of the recovery

There is no guarantee that the strong private demand will continue.

Household income has held up, but with fiscal support coming to an end and accumulated savings being drawn down, consumption could take a hit.

With businesses in many countries already heavily indebted before the pandemic – and leverage having increased further, corporate investment may be low.

The evolution of inflation

Thus, a key question is how persistent inflation pressures will prove to be. Although it is still unclear when bottlenecks will eventually clear, taking the pressure off prices, especially if the bullwhip effect goes into reverse. The key to where global inflation is headed is rather in wage setting.

So far, inflation expectations appear to be anchored. They have increased much more for the near term than the medium term, including in emerging market economies. But we do not know if they will remain so. The risk of un-anchoring increases with inflation itself.

Wage pressures could be a game-changer. So far, aggregate wage growth has been moderate, notwithstanding large rises in certain sectors, such as leisure and hospitality and transportation, notably in the United States. But, again, we do not know how much slack there is and how it will evolve.

Central banks face a difficult balancing act

A recovery together with rising inflation is an unpleasant combination. While not a new phenomenon, it poses a difficult balancing act for central banks. The challenges are even greater if wage pressures break through before inflation starts to moderate.  

In addition, there are trade-offs stemming from public and private debt levels that are very high, and central bank balance sheets have rarely been as large as now.

Fiscal and monetary policies reinforced each other during the Covid-19 crisis, but their interactions could now give rise to tensions. Some countries have already applied the fiscal brakes. Large advanced economies also expect significant fiscal consolidation in 2022 and 2023.

Years of accommodative policy have generated froth in many financial markets. Some advanced economies are especially vulnerable, with some risky asset prices continuing to soar during the pandemic.

At the start of the pandemic, central bankers made difficult decisions in the face of both known unknowns and unknown unknowns. Since then, central bankers have learned and adapted. They need to continue to react forcefully, yet flexibly.

Staying ahead of the inflation curve and clearly signalling a path towards normalisation will be essential. This will also help ease the intertemporal trade-off by mitigating the build-up of financial vulnerabilities fuelled by easy financial conditions in housing markets, the corporate sector and among non-bank financial intermediaries.

A brave new digital world

As if the monetary policy juggling act were not enough, central banks face the additional challenge of a rapidly changing financial landscape due to digital innovation. The very meaning and future of "money" is at stake.

Stablecoins issued by big techs could compete with national currencies and each other. A big tech stablecoin may be an attractive proposition at first sight but it raises fundamental questions about trust in the monetary system since it would entail handing over the keys to a few dominant and profit-driven private entities that are accountable only to their shareholders. For the most part, stablecoins have grown by importing their value from collateral in the form of central bank money or other regulated financial instruments, without stablecoins themselves having the requisite oversight.

Big tech financial services activities thus need to be properly regulated, to safeguard financial stability and address any competitive distortions relative to banks. Private stablecoins need also to be adequately regulated to address the risks they pose, such as runs, payment system dislocations and concentration of market power.

Another risk is so-called decentralised finance (DeFi), which envisions the replacement of institutions with distributed ledger technology (DLT) with the aim of reclaiming data from big techs and "cutting out the middlemen" such as big banks.

To date, the DeFi space is primarily used for speculative activities; it is a parallel financial system with little to no oversight, and it facilitates illegal activities. At a structural level, it depends on rents to maintain trust in an anonymous system. Insiders win while efficiency gains for average users have so far failed to materialise.

In addition, DeFi is subject to the same vulnerabilities – high leverage and liquidity mismatches – as traditional financial services are. It also has connections to the formal financial system. Stablecoins in DeFi may not be sound money. In the absence of proper regulation, they may lack full backing or test the definition of a safe asset. Thus, DeFi too threatens the soundness of the financial and monetary systems.

A better approach to shaping the future of money would be to ensure a market structure that fosters competition and innovation with the aim of creating an open and global monetary system. Central banks should continue to stand at the core of this system, building on the trust already placed in them. Central bank credibility should be reserved for public goods, not borrowed by DeFi and stablecoins that serve other interests. The issuance of well-designed central bank digital currencies (CBDCs) can play a key role.

Importantly, central banks can work with the private sector and with each other to ensure interoperability domestically and across borders. The private sector could interact with clients and build a host of financial services on top of such a system. The BIS Innovation Hub is working to make this vision a reality.

Concluding remarks

Let me conclude with one more thought. The pandemic should encourage a sense of humility about what is possible. In times like this, as Meg Wheatley puts it, "we don't need more command and control; we need better means to engage everyone's intelligence in solving challenges and crises as they arise." From a central banker's perspective, this puts effective communication and engagement with the markets and the broader public at an even greater premium.

I am looking forward to the discussion.