New-model central banks

BERKELEY  —  We are used to thinking about the remit of central banks as focusing narrowly on price stability, or at most as targeting inflation while ensuring the smooth operation of the payment system. But with the global financial crisis of 2008 and now COVID-19, we have seen central banks intervening to support a growing range of markets and activities, using instruments that extend well beyond interest rates and open market operations.

An example is the US Federal Reserve’s Paycheck Protection Programme Liquidity Facility, under which the Fed provides liquidity to lenders who extend loans to small businesses in pandemic-related distress. This, clearly, is not your mother’s central bank.

Now we hear calls to broaden this ambit still further. European Central Bank (ECB) President Christine Lagarde and Fed board member Lael Brainard have each urged central banks to tackle climate change. Against the backdrop of the Black Lives Matter movement, US Representative Maxine Waters of California has pushed Fed Chair Jerome Powell to do more about inequality, including specifically racial inequality.

Such calls horrify central-banking purists, who warn that charging central banks with these additional responsibilities risks diverting them and their policy instruments from their primary objective of inflation control. They caution that monetary policy is a blunt instrument for tackling climate change and inequality, which can be more effectively addressed by taxing carbon emissions or strengthening equal housing laws.

Above all, the critics worry that pursuing these other objectives will jeopardise central banks’ independence. Central banks enjoy operational independence in order to pursue a specific mandate, because there is a consensus that the mandated objectives are best taken out of elected officials’ hands. But independence does not mean central bankers are unaccountable to politicians and public opinion. They must justify their actions and explain how their policy decisions advance the mandated objectives. Their success or failure can be judged by whether or not the central bank achieves its independently verifiable targets.

With a greatly expanded mandate, the relationship between policy instruments and targets would become more complex. Justifications for policy decisions would be harder to communicate. Success or failure would be more difficult to judge. Indeed, insofar as monetary policy has only limited influence over climate change or inequality, targeting such variables would be setting up the central bank to fail. And frustration over failure might lead politicians to rethink the central bank’s operational independence.

These arguments are not without merit. At the same time, central bankers cannot snooze quietly in their bunks in the face of an all-hands-on-deck emergency. Calls for central banks to address climate change and inequality reflect an awareness that these problems have risen to the level of existential crises. If central bankers ignored them, or said, “These urgent problems are best addressed by someone else,” their response would be seen as a haughty and perilous display of indifference. At that point, their independence would truly be at risk.

So, what to do? Central banks as regulators have tools with which to address climate change, and their responsibility for ensuring the integrity and stability of the financial system gives policymakers the mandate to use them. They can require more extensive climate-related financial disclosures. They can impose stricter capital and liquidity requirements on financial institutions whose asset portfolios expose them to climate risk. Such tools will discourage the financial system from underwriting brown investments.

The challenge of understanding the risks to financial stability from climate change is that climate events are irregular and nonlinear. When modeling them, it will be important for central banks to avoid the mistakes they made in modeling COVID-19. Those problems arose because economists and epidemiologists worked in their separate silos. So, one might ask advocates like Lagarde and Brainard: How many climate scientists have central banks hired? When will they start?

When it comes to inequality, some central banks already have the relevant mandate. In the United States, the Community Reinvestment Act of 1977 tasks regulators, including the Fed, with ensuring that low- and moderate-income families have adequate access to credit. The Fed has delegated this responsibility to its 12 regional reserve banks, each of which fulfills it in different ways. Stronger guidance from the Federal Reserve Board on exactly how to ensure equal access to credit, with explicit attention to racial disparities, would reinforce existing efforts.

It would be a departure for other central banks, such as the ECB, to address the credit access of minority and underprivileged groups. But the European Parliament can so instruct it. And the ECB board can work with the national institutions that make up the European System of Central Banks in meeting that call.

Monetary policy has implications for issues beyond inflation and payments, including climate change and inequality. It would be disingenuous, even dangerous, for central bankers to deny those connections, or to insist that they are someone else’s problem. The best way forward for central bankers is to use monetary policy to target inflation, while directing their regulatory powers at other pressing concerns.

Barry Eichengreen is professor of Economics at the University of California, Berkeley. His latest book is “The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era”. Copyright: Project Syndicate, 2021. 

www.project-syndicate.org