Central Banks in the 21st Century: Independence, Credibility, and Interest Rate Challenges

Central banks

The situation with central banks looks decidedly different to the 1970s, for two key reasons. First, while the response to the initial Covid wave was huge – and in hindsight probably too aggressive – policymakers have not shied away from applying the brakes ever since. No central banker wants to be remembered as the modern-day Arthur Burns, and there’s a clear incentive to err on the side of keeping rates too high for too long. While we expect rate cuts in 2024, it’s highly unlikely that rates will return to the ultra-low levels seen before the Covid pandemic. Meanwhile, central bank balance sheets are increasingly likely to be used for targeted financial stability interventions rather than to deliver large monetary stimulus.

 

The other major difference is that central banks are now independent, whereas with the exception of the German Bundesbank, that largely wasn’t the case in the 1970s. This independence, as well as monetary tightening in the 1980s, laid the basis for lower inflation expectations. Since the 1980s, central bank credibility has become an important asset in the fight against inflation. Therefore, central banks will be less inclined to ease monetary policy when inflation expectations are still high.

Will that change? It’s unlikely, and independence has so far survived the era of populism relatively unscathed, at least among G10 economies. High interest rates are likely to be a key topic going into elections in the US and UK, among others, in 2024. But ultimately, central banks will be reluctant to return to the days of ultra-low rates.