Is the Golden Age of central banking over?

New CEPR/ICMB Geneva Report on the World Economy

The 25 years from 1982-2007 were a golden age for central banking. Armed with independence and mandates that allowed monetary policy to focus on achieving and sustaining price stability, central banks created a framework that successfully delivered low inflation and set the scene for almost two decades of strong economic growth.

The present crisis has brought this golden age to an end, at least temporarily, according to the latest CEPR/ICMB Geneva Report on the World Economy. The Report examines two key challenges facing central banks in the aftermath of the financial crisis.

A first challenge that central banks face is to exit from the present very substantial monetary stimulus in a way that is consistent with both the maintenance of low inflation and preservation of their financial independence. Central banks must be vigilant in removing the current monetary stimulus in a timely fashion: neither too soon, which could damage the recovery, nor too late, which could lead to a sustained inflation episode. Moreover, as we exit from the crisis, central banks need to unwind the very substantial increase in their balance sheets that have taken place as a result of the quantitative and credit-easing policies introduced over the past two years. Failure to do so would put central banks' financial independence at risk in those cases where their unconventional monetary operations have exposed them to potential financial losses.

A second challenge central banks face is how to enhance their monetary policy frameworks on the basis of the lessons learned during the crisis. While the authors' view is that monetary policy should continue to aim at delivering price stability, and financial regulation should take care of financial stability, clearly both policies cannot be conducted in isolation. Specifically, they should both incorporate a macroprudential component. As regards monetary policy, this means that the risk of financial imbalances should be more fully taken into account when setting interest rates, which also requires that central banks receive adequate information from the supervisory authorities concerning the state of the financial system. In practice, this means that monetary policy should be more willing to lean against large increases in credit and indebtedness, particularly where accompanied by rapid increases in asset prices. This would make monetary policy more symmetric over the cycle since more 'leaning' in good times will be accompanied by the need to do less 'cleaning' in bad times.

Charles Wyplosz, Director of the International Centre for Monetary and Banking Studies, added:

'The second Geneva Report on the World Economy ("Asset Prices and Central Bank Policy") made essentially the same proposal in 2000. Nine years ago the merits of the inflation-targeting framework seemed so obvious that this proposal received little attention. The policy landscape has changed radically and I'm confident that this time round the ideas in the tenth Geneva Report will be discussed seriously.'

The authors of the report are:

• Stefan Gerlach, Institute for Monetary and Financial Stability at University of Frankfurt and CEPR
• Alberto Giovannini, Unifortune Asset Management
• Cédric Tille, Geneva Graduate Institute for International and Development Studies and CEPR
• José Viñals, Banco de España and CEPR