Central banks should resolve to adopt a more humble approach to central banking

Central banks cannot solve all that ails our economies. They should not be expected to solve problems that other actors can better address, such as collective global goals outside their fields of competence. Instead, they should focus on three objectives: price stability, financial stability and macro-economic stability. Achieving these is hard enough. We should dial back public expectations that central banks can or should do more.

So, what does a humble approach to central banking mean in practice? For starters, central banks need to be more realistic about their ability to forecast macro outcomes with great precision. Their recent track record has shown this. If we look at the US Federal Reserve Board and the ‘hair’ diagram, as inflation jumped, staff economists repeatedly projected a return to 2% inflation from wherever the current estimate stood. Again and again, the forecasts were wrong—and in both directions. Others have suffered similar failures, as most forecasting models have a return to an inflation anchor of 2% ‘baked in.’ Advanced-economy central banks misread early indications of an inflationary spike with which we’re still grappling, owing to the wrong belief that those price hikes were transitory. This led to a lag in monetary- policy responses, which exacerbated the height of the inflationary spike and the economic pain that ensued, and ultimately required historically steep interest-rate hikes.

Policy decisions were muddied further by the adoption of new or adjusted monetary-policy frameworks during a prolonged period of low inflation earlier. These models had assumptions that slowed responses when exogenous shocks (the pandemic), supply shocks (its trade impact) and fiscal shocks (the size and persistence of the stimulus set off by covid) hit inflationary pressures and outcomes.

First things first: A key part of adopting a humble approach would require policymakers to return to fundamental, time-tested principles of macro- and monetary economics. They must avoid over-reliance on specific predictive models of inflation. Ideally, central banks should develop frameworks that achieve reasonable forecast results, regardless of the nature of the shock hitting the economy, and communicate the degree of uncertainty to markets and the public. In doing so, they can preserve the option of shifting policy stances as circumstances change, rather than promising long periods of policy stasis based on problematic assumptions.

A humble approach would also require central banks to preserve future policy space. In this recent suboptimal policy-setting cycle, many locked themselves into stances that constrained their ability to act swiftly via long-term policy commitments when the economic situation shifted suddenly, like when inflation reared its head. Central banks should tilt towards simpler and more transparent rules, rather than drastic long-term discretionary measures that threaten to undermine their future ability to act.

Crucially, embracing the humble approach requires central banks to keep their focus on the inflation anchor. The world’s major central banks have converged on a 2% target. Now is not a time to question or lose sight of that goal. Suggesting doctrinal flexibility or raising targets at a time of higher price growth and worries over long-term expectations is the wrong answer. Central banks must remain committed to preventing inflation from spiralling out of control, and their credible commitment to an inflation anchor is key. A central bank can temporarily let inflation run above target if it fears severe consequences from raising rates, but its reputation will be eroded. For inflation expectations not to stray from the target, the central bank must be widely seen as competent.

Avoid financial dominance: Some pundits now believe that the worst is behind us and we can relax. We disagree. Around the world, public debt levels are high, and with interest rates rising and payments growing, issues of debt sustainability have come to the fore. Expect tensions between the necessity of tighter monetary and fiscal policies and governments’ desire to relieve pain. Governments may put political pressure on central banks to keep interest rates low or lower than needed. As costs loom for the public and governments, a ‘blame game’ will arise in which policymakers try to avoid blame for inflation. We must be clear about the absolute need to control inflation and secure central-bank credibility.

Given high private debt and leverage levels, we worry about the emergence of a new regime of ‘financial dominance.’ In this situation, central banks may be loath to tighten monetary policy because of worries about risks to the stability of financial markets, which have become perhaps too reliant on central-bank support. Bank failures in the US and Europe in the first half of 2023 showed this link, and the prolonged nature of central-bank support may still hide sources of instability when policymakers finally withdraw support from addicted firms and sectors.

Central bankers are right to worry about such risks, which partly reflect their own past actions. But to avoid succumbing to financial dominance, central banks’ supervisory wings must deal with the negative spillover effects of past monetary- policy largesse as rates tighten.

Independence is everything: To achieve their core goals, central banks require independence from political interference. With this comes a heavy burden of responsibility, which is a key reason why central bankers must accept the narrow mandate implied by a humble approach.

Independence is also best served when central banks communicate policies clearly and effectively, and there has been progress on this. It is appropriate that governors testify to legislators and answer questions raised by elected officials. People and other market participants need to understand why and when central bankers act.

The real test comes when necessary policy tightening causes public-debt levels and payments to rise. As governments confront hard fiscal decisions, the danger to central-bank independence rises. We know what a lack of it is like; ask residents of Argentina or Turkey about sky-high inflation. The economic effects are real, impoverishing and socially devastating. Crucially, once inflation is allowed to take hold, if independence and credibility are lacking, people’s inflationary expectations are adversely affected, and the results can be very harmful. Only with operational independence can central banks continue to fulfil their price stability and other related mandates, learn from policy mistakes, address ongoing inflationary pressures and chart a way forward, mindful of emerging and morphing risks.

Here, we can learn a valuable lesson from emerging-market central banks. The improved resilience and performance of emerging markets is due in part to the lessons learnt from their severe debt and macroeconomic crises in previous years. While advanced-economy central bankers delayed responding to the recent bout of inflation, believing that it was transitory (and thereby raising the cost and monetary-policy pain needed in the end), emerging-market central banks acted early as inflationary impulses turned visible, hiked policy rates aggressively and quickly either halted or reversed inflation.

As advanced-economy central bankers assess their recent policy responses, failures and lessons learnt, they should recognize where others got it right and where they got it wrong. Humility requires nothing less.

Markus Brunnermeier contributed to this article. ©2023/project syndicate