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How much should tomorrow’s central bank balance sheets do? And what central banks can learn from parenting

Summary:
Andrew Hauser of Bank of England in this speech discusses role of central bank balance sheets in monetary policy in future: Central banks can’t choose whether to take the actions necessary to deliver their monetary and financial stability mandates: they are obligated to do so. But they do have choices about how they go about it – and a key factor in those judgments is the role they want financial markets to play. In my remarks today, I want to do three things. First, to show just how dramatically the role of central bank balance sheets has changed in recent years, and the forces shaping the future. Second, to review the complex and shifting inter-relationships between central banks and financial markets over history. And, third, to suggest some possible principles for shaping central

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Andrew Hauser of Bank of England in this speech discusses role of central bank balance sheets in monetary policy in future:

Central banks can’t choose whether to take the actions necessary to deliver their monetary and financial stability mandates: they are obligated to do so. But they do have choices about how they go about it – and a key factor in those judgments is the role they want financial markets to play. In my remarks today, I want to do three things. First, to show just how dramatically the role of central bank balance sheets has changed in recent years, and the forces shaping the future. Second, to review the complex and shifting inter-relationships between central banks and financial markets over history. And, third, to suggest some possible principles for shaping central bank operations of the future in ways that harness the benefits of financial markets.

Hauser shows how central bank balance sheets have grown across most countries. He then goes back to the history of central bank balance sheets and its relation with financial markets. He connects the relationship to parenting:

While central banks outgrew these teenage tendencies and began acting more clearly as parents in the twentieth century, their role continued to co-evolve closely with that of financial markets:

  • The period from the Great Depression in the 1930s to the 1960s/70s saw central banks acting as ‘authoritarian’ parents, reflecting low affection for the market, and a high desire for control. A panoply of macroeconomic, regulatory and market-facing interventions aimed to shape and channel markets to social ends.
  • Just as authoritarian parenting is often the architect of its own downfall, the efficacy of these controls was ultimately undermined by a rebellion on the part of the markets. The development of eurobonds, largely outside the controls erected by central banks, undermined constraints on credit creation and the Bretton Woods regime of fixed exchange rates. That collapse in authority, amplified with a broader concern about ‘government failure’, led ultimately to the ‘indulgent’ parenting regime of the 1980s – in which high affection for the market led to a stripping away of controls. Central bank balance sheets during this period hit a cyclical low (Chart 1), and inflation targeting became the dominant monetary regime.
  • The indulgent phase ended in 2008-9, with the GFC. Whilst inflation targeting continued on the monetary policy side, the subsequent 15 years saw a return to a desire for greater control over market forces, reflected in new global and national frameworks for microprudential, macroprudential and conduct regulation.

Greater control returns us to the right hand column of the model in Table 1. The question then is whether we aspire to be ‘authoritarian’ or ‘authoritative’ – which depends on our attitude to financial markets. And here we face a conflict. Households and firms rely on financial markets like never before – so we need them to thrive. But we also need them to be safe: we cannot risk exposing economies again to the sorts of volatility and cost experienced in 2008-09, or those that could have occurred in 2020 had the policy response not been swift and decisive. And we need to continue to achieve our monetary policy goals.   

Interesting to see how central banks are using all kinds of metaphors to explain their work and relevance..

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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