The Banking Executive Magazine, Issue 154, October 2021

Central Banks’ Additional Roles With time, central banks have been granted extra objectives and have stretched their policy toolkits accord- ingly, particularly when called upon to prevent major shocks from trigger- ing global depressions. But with pol- icy innovation comes new risks, not least to central banks’ independence. People have rarely heard that, for ex- ample, the US Federal Reserve has a dual mandate to promote both price stability and maximum employment. Under the Federal Reserve Reform Act of 1977, the Fed also has a third mandate: to ensure moderate long- term interest rates. There is nothing unusual about this objective. Central banks over the years have sought to prevent sudden increases in government bond yields. In the 1930s, for example, the US Treasury wanted the Fed to cap bond yields, leading to a compromise whereby the Fed agreed to maintain orderly market conditions. Even the landmark Treasury-Fed Accord of 1951, which restored the central bank’s independence after World War II, required the Fed to “assure the successful financing of the gov- ernment’s requirements and, at the same time, to minimize monetiza- tion of the public debt.” In fact, the Fed has a fourth objec- tive, because it (like virtually all other central banks) is responsible for en- suring a stable financial system. The catch, here, is that most major cen- tral banks before the 2008 financial crisis had only one monetary policy instrument with which to carry out these tasks: the overnight interest rate in interbank markets. Hence, con- ventional academic thinking in the 1990s focused on a single, short- term instrument, which proved very convenient for keeping central banks out of political trouble. But having more objectives than pol- icy instruments is a violation of the famous Tinbergen Rule, so named for Jan Tinbergen, the Dutch economist who won the first Nobel Memorial Prize in Economic Sciences in 1969. Tinbergen argued that (n) policy ob- jectives require (n) independent pol- icy instruments, and in the aftermath of the 2008 crisis, central banks rose to the challenge by transforming their balance sheets into a key instrument of monetary policy. This development was not purely a consequence of the policy rate hit- ting the zero lower bound, nor was it particularly unconventional, con- sidering that central banks have al- ways made extensive use of their balance sheets. Nonetheless, we have yet to feel the full economic im- pact of a larger and more diverse pol- icy toolkit. EUROPEAN CENTRAL BANK When the short-term interest rate was its only instrument, the same monetary policy applied for all euro- zone members irrespective of na- tional circumstances. With a balance-sheet policy, it could partly address this gap in the name of pur- suing 2% inflation throughout the eurozone. For example, a special medium-term lending program for banks (with the same conditions ap- plying to all) is attractive to banks in countries with poor market access or where bank loans are more expen- sive. A similar argument can be made for buying financial assets in markets under pressure. The ECB’s balance-sheet policies can therefore provide greater monetary stimulus in countries where it is most needed. In a recent statement about its monetary policy strategy review, it emphasized the continued use of “asset purchases and longer-term re- financing operations,” and that it would “consider, as needed, new policy instruments.” Putting the balance sheet at the cen- ter of monetary policy amounts to a ISSUE 154 OCTOBER 2021 the BANKING EXECUTIVE 9