Hindsight is, of course, 20/20. The pandemic was unprecedented and its consequences for the globalized economy very hard to predict. The fiscal response, perhaps much more generous because polarized legislatures could not agree on whom to exclude, was not easy to forecast. Few thought Vladimir Putin would go to war in February 2022, disrupting supply chains further and sending energy and food prices skyrocketing.
Undoubtedly, central bankers were slow to react to growing signs of inflation. In part, they believed they were still in the post-2008 financial crisis regime, when every price spike, even of oil, barely affected the overall price level. In an attempt to boost excessively low inflation, the US Fed even changed its framework during the pandemic, announcing it would be less reactive to anticipated inflation and would keep policies more accommodative for longer. This framework was appropriate for an era of structurally low demand and weak inflation but exactly the wrong one to espouse just as inflation was about to take off and every price increase fueled another. But who knew the times were a-changing?
Even with perfect foresight—and in reality, they are no better informed than capable market players—central bankers may still have been understandably behind the curve. A central bank cools inflation by slowing economic growth. Its policies have to be seen as reasonable or else it loses its independence. With governments having spent trillions to support their economies, employment just recovered from terrible lows, and inflation barely noticeable for over a decade, only a foolhardy central banker would have raised rates to disrupt growth if the public did not yet see inflation as a danger. Put differently, preemptive rate rises that slowed growth would have lacked public legitimacy—especially if they were successful and inflation did not rise subsequently. Central banks needed the public to see higher inflation to be able to take strong measures against it.
In sum, central bank hands were tied in different ways—by recent history and their beliefs, by the frameworks they had adopted to combat low inflation, and by the politics of the moment, with each of these factors influencing the others.
Yet stopping the postmortem at this point is probably overly generous to central banks. After all, their past actions reduced their room to maneuver and not just for the reasons just outlined. In particular, take the emergence of both fiscal dominance (whereby the central bank acts to accommodate the government’s fiscal spending) and financial dominance (where the central bank acquiesces to the imperatives of the market). They clearly are not unrelated to central bank actions of the past few years.
Long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging. And both the government and the private sector levered up. Of course, the pandemic and Putin’s war pushed up government spending. But so did ultra-low long-term interest rates and a bond market anesthetized by central bank actions such as quantitative easing. Indeed, there was a case for targeted government spending financed by long-term debt issues. Yet sensible economists making the case for spending did not caveat their recommendations enough, and fractured politics ensured that the only spending that could be legislated had something for everyone. And, of course, politicians, as always, drew on unsound but convenient theories (think Modern Monetary Theory) that gave them the license for unbridled spending.
While central banks can make the case that they were surprised by recent events, they played a role in constraining their own policy space.
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.
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