Central banks have evolved. Are they still fit for purpose?

Customers queue to enter a Northern Rock bank branch in Bromley

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How has monetary policy shifted?

Over the past 25 years, monetary policy in advanced economies has undergone an astonishing, unprecedented transformation – dramatically changing in both scope and scale, and blurring the boundaries with fiscal policy. When MoneyWeek published its first edition, there was a broad consensus on inflation targeting, operational independence for central banks and faith in the ability of short-term interest rates to stabilise output and prices. But those turbulent 25 years have seen a radical shift. From the “Greenspan put” to quantitative easing (QE – printing money to buy government debt), monetary policy has evolved in ways that are highly controversial and politicised. Central banks today have vastly higher balance sheets, in some cases manage entire yield curves (that is, use policy to influence rates across different maturities of government bonds, not just short-term rates) and openly coordinate with fiscal authorities in emergencies.

Why is this controversial?

Because, critics argue, the gigantic balance sheets held by unelected central banks as the result of QE, and their “unconventional” monetary policies, have inflated asset-price bubbles, fostered inequality, led to misallocation of capital, and masked unsustainable public finances. Long-term, the chief purpose of monetary policy is to inspire confidence in the value of money by encouraging price stability. In the short or medium term, the aim of policy is to keep the real economy stable – supporting sustainable growth and employment – and to contain risks. Since the turn of the century, however, independent central banks have radically over-interpreted that brief by consistently coming to the rescue of equities and debt markets in ways that have distorted business cycles and deferred pain. Emergency measures have become the norm, and central banks have ballooned.

How have central banks expanded?

For almost the whole of the 20th century, the central-bank assets of advanced economies, as a proportion of economic output, remained remarkably constant, at around 10%-13% of GDP. But in the aftermath of the great financial crisis of 2007-2008 – as governments everywhere turned to QE – that proportion surged, rising above 20% in 2009-2010. And rather than falling back to normal levels as the crisis stabilised, that proportion then doubled once more during the 2010s to 40% – before spiking up to 70% in the aftermath of Covid. Even by 2024, it was still 50%. That’s a revolutionary change in the size of central banks’ financial assets within a couple of decades. Historically, balance sheets merely reflected operations. Now, they are strategic levers shaping long-term yields and risk premiums – a fundamental conceptual shift.

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Was QE justified?

Yes, in the immediate aftermath of the financial crisis, decisive action by central banks was vital in stabilising economies and preventing deflation, says Andy Haldane in the Financial Times. By contrast, “later-stage QE, including purchases made in response to Covid, is harder to justify. With fiscal policy highly expansionary, QE’s primary purpose was to placate fretful bond markets rather than boost inflation” – a worrying step towards “fiscal dominance”. Vincent Reinhart, the chief economist at BNY Investments, co-authored two research papers on QE with Ben Bernanke, chairman of the Federal Reserve from 2006-2014, who instituted QE following the financial crisis. “We did not include a section on how to get out of the policy, or the risks stemming from it,” he now says. “That was a mistake – it was a lot stickier than I thought going in and has opened up a range of complications and potential political influences on monetary policy.”

So it’s been hard to get out of?

Indeed. The current era of gigantic public debt has blurred the lines between monetary and fiscal policy, since rate rises (or quantitative tightening) put up debt-servicing costs and infuriate the likes of Donald Trump. In the UK, quantitative tightening triggers indemnities that require the Treasury – ultimately, the taxpayer – to cover central-bank losses. In addition, by pushing up gilt yields, it makes it more expensive to the Treasury to borrow and service its debts. That makes monetary policy more politically charged than ever, and the target of populists who regard central bankers as sources of unelected and illegitimate technocratic power.

What are the limits on monetary policy?

Conventional monetary policy is a famously blunt tool. It has become blunter in recent decades. Financial globalisation and the absorption of China into the global economy, technological change and demographic ageing have lowered real rates. There’s been a relative decline in floating rate debt, meaning rate changes do not necessarily feed through into the wider economy. And rate-sensitive capital-intensive sectors, such as manufacturing and construction, have diminished in favour of services, which are more labour-intensive and less responsive to interest rates, says Marco Casiraghi, director at Evercore ISI. All of this makes monetary policy harder to frame and execute with confidence.

A tough gig, then?

The Bank for International Settlements says that everyone, from governments to central banks to investors and consumers, needs to become more realistic about monetary policy. The idea that it alone can underpin growth is an “illusion”. And the trade-offs that monetary policy involves will “become unmanageable” without “more holistic and coherent policy frameworks in which other policies – prudential, fiscal or structural – play their part”. Central bankers may be even more powerful than 25 years ago. But in an ever more complex and turbulent century, even they recognise that they are not magicians.

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