The Case for and against Central Bankers

Central banks compounded the problem by buying government debt financed by overnight reserves, thus shortening the maturity of the financing of the consolidated balance sheet of the government and the central bank. This means that as interest rates rise, government finances, especially for slow-growing countries with significant debt, are likely to become more problematic. Fiscal considerations already weigh on the policies of some central banks—for instance, the European Central Bank worries about the effect of its monetary actions on “fragmentation,” the yields of debts of fiscally weaker countries blowing out relative to the yields of stronger countries. At the very least, perhaps central banks should have recognized the changing nature of politics that made unbridled spending more likely in response to shocks, even if they did not anticipate the shocks. This may have made them more concerned about suppressing long rates and espousing “low for long” policy rates.

The private sector also levered up, both at the household level (think Australia, Canada, and Sweden) and at the corporate level. But there is also a new, largely overlooked, concern—liquidity dependence. As the Fed pumped out reserves during quantitative easing, commercial banks financed the reserves largely with wholesale demand deposits, effectively shortening the maturity of their liabilities. In addition, in order to generate fees off the large volume of low-return reserves sitting on their balance sheets, they have written all sorts of liquidity promises to the private sector—committed lines of credit, margin support for speculative positions (think of how much banks were on the hook for rogue fund Archegos’s speculative positions), and so on. The problem is that as the central bank shrinks its balance sheet, it is hard for commercial banks to unwind these promises quickly. The private sector becomes much more dependent on the central bank for continued liquidity. We had a first glimpse of this in the UK pension turmoil in October 2022, which was diffused by a mix of central bank intervention and government back-tracking on its extravagant spending plans. The episode did suggest, however, a liquidity-dependent private sector that could potentially affect the central bank’s plans to shrink its balance sheet to reduce monetary accommodation.

High asset prices, high private leverage, and liquidity dependence suggest the central bank could face financial dominance—where monetary policy responds to financial developments, such as a sharp fall in financial asset prices, rather than inflation. Regardless of whether it intends to be dominated or not, current private-sector forecasts that the Fed will be forced to cut policy rates quickly have made the Fed’s task in removing monetary accommodation harder. It will have to be harsher for longer than it would want to be, absent these private-sector expectations. And that means greater adverse consequences to global activity. It also means that when asset prices reach their new equilibrium, households, pension funds, and insurance companies will all have experienced significant losses—and often, these are not the entities that benefited from the rise. The bureaucratically managed, the unsophisticated, and the relatively poor get drawn in at the tail end of an asset price boom, creating problematic distributional consequences that the central bank has some responsibility for.

Finally, one area where reserve country central bank policies have had effect but have had very limited consequences for their actions is on external spillovers. Clearly, the policies of the core reserve countries affect the periphery, through capital flows and exchange rate movements. The periphery has to react, regardless of whether its policy actions are suitable for domestic conditions, failing which it suffers longer-term consequences such as asset price booms, excessive borrowing, and eventually debt distress.

In sum, then, while central banks can make the case that they were surprised by recent events, they played a role in constraining their own policy space. With their asymmetric and unconventional policies, ostensibly intended to deal with the policy rate touching the lower bound, they have triggered a variety of imbalances that not only make fighting inflation harder but also create new problems for the world. Central banks are not innocent bystanders, and the fact that their role in precipitating the Global Financial Crisis was not adequately highlighted has given them a freedom of action that has resulted in new fragilities.

Excerpted from Monetary Policy and Its Unintended Consequences by Raghuram G. Rajan. Reprinted with permission from the MIT Press. Copyright 2023.

Raghuram G. Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth and was the 23rd governor of the Reserve Bank of India from 2013 to 2016.