Back to the future: intellectual challenges for monetary policy

BIS Working Papers  |  No 981  | 
25 November 2021



The central banking community faces daunting challenges, which may well define the future of the central bank as an institution for years to come. These entwined challenges are economic, intellectual and institutional. This lecture focuses on the intellectual challenge, ie the facts on the ground are increasingly testing the long-standing analytical paradigms on which central banks may rely to inform their policies. 


The lecture examines the intellectual challenge from a holistic perspective, considering its evolution, causes and implications. In so doing, it critically revisits beliefs so ingrained that they are often taken as self-evident, even though they have not always been regarded as such. Are these beliefs fully justified?


In the years ahead, rebuilding room for policy manoeuvre – monetary buffers – will be essential. Regaining such safety margins is critical to allow monetary policy to fulfil its mandate effectively – tackling price, macroeconomic and, hence, financial instability. Three beliefs may complicate this task. First, economic fluctuations reflect exogenous shocks rather than inherently unstable dynamics. Second, monetary policy has only a transient impact on the real economy ("money neutrality") and hence also the real (inflation-adjusted) rate of interest (the "natural rate of interest"). Third, the costs of persistent falls in the price level – deflation – are large. These beliefs may be less justified than normally thought.


The central banking community is facing major challenges – economic, intellectual and institutional. A key economic challenge is the need to rebuild room for policy manoeuvre, which has fallen drastically over time. This lecture focuses on the intellectual challenge, ie facts on the ground are increasingly testing the longstanding analytical paradigms on which central banks can rely to inform their policies. It argues that certain deeply held beliefs underpinning those paradigms can complicate the task of regaining policy headroom.

Keywords: monetary policy, business cycle, financial cycle, inflation, deflation, natural interest rate.

JEL classification: E43, E51, E52, E58, E31.