Current challenges for central banks

Remarks prepared for delivery by Mr Agustín Carstens, General Manager of the BIS, at the Institute of International Finance Board Meeting, Zurich, Switzerland, 15 January 2023.

First of all, let me thank the organisers for giving me the opportunity to address you tonight. I will focus my remarks on the challenges central banks are currently facing. The obvious starting point is the return of inflation, something we at the BIS have focused a lot of our research efforts on over the past year.

The outlook for inflation

The recent surge of inflation has been global and broad-based. No doubt, two key triggers were the shocks the global economy has faced over the past three years. First came the pandemic, with its legacy of supply chain disruptions. On top of this came the Russian invasion of Ukraine and its impact on global commodity prices.

During the post-pandemic recovery, inflation proved broader and more persistent than we and others initially expected. Rising input costs spread along global value chains at a time when economies were re-opening and demand was picking up. Demand was also boosted by accommodative monetary and fiscal policy, following measures by central banks and other policymakers to stave off the pandemic's impact on firms, households and the wider economy and financial system.

Inflation now seems to have reached a turning point in several jurisdictions, not least the United States, which plays a critical role for interest rates globally. To be sure, this has in part been thanks to retreating commodity prices. But monetary policy also deserves some credit. Once it became apparent that inflation could become entrenched, central banks acted forcefully to stem rising prices and rein in inflation, in line with their mandates to preserve price stability.

This does not mean that the battle has been won: the next stage could be even harder. Even if commodity prices recede further, the spillovers of higher input costs to other sectors remain and may take longer to fade. Closely related to this, we see that inflation in the service sector, which is typically more stubborn, has been picking up and is still on the rise in several jurisdictions.

More generally, the longer inflation stays well above target, the higher the risk of a transition to a high-inflation regime, as we outlined in our Annual Economic Report 2022. In such a regime, hard-to-reverse behavioural changes set in and reinforce inflation pressures. This makes it even more costly to bring inflation back under control.

Central banks will need to keep their hands firmly on the yoke to ensure that inflation returns to target reasonably soon. Attention is now shifting from how quickly to raise rates, to how far and for how long to keep them there. We should not underestimate the risk of declaring victory too early, remembering that inflation has the largest impact on the most vulnerable in our society.  

It is also important that governments support central banks' efforts, as they did to good effect during the pandemic, and that their actions are complementary towards the common goal of supporting a smoothly functioning economy. Expansionary fiscal measures to cushion the effects of tighter monetary policy on economic growth would complicate this task and will ultimately be ineffective. Central banks would not stand idly by and allow their economies to overheat. Instead, they would raise interest rates by more to offset the effects of fiscal expansion.

Policy tightening in a high-debt world

The path central bankers must navigate to successfully tame inflation is challenging given historically high levels of debt, both private and public.

The long phase of aggressive risk-taking in financial markets when interest rates were held low following the Great Financial Crisis (GFC), and high property prices in a number of jurisdictions, highlight the risks linked to these pockets of vulnerabilities. For example, high debt held by firms and households makes aggregate demand more sensitive to a tighter monetary policy stance. Policy tightening has a larger impact on the cost of servicing loans and makes balance sheets more vulnerable. The complicating factor for policymakers is that it is difficult to say how much that sensitivity has increased or when reactions might come.

Likewise, high public debt amplifies the impact of monetary policy tightening and makes it more unpredictable. This applies to both higher policy rates and – a historically new element – quantitative tightening, when asset purchases made during difficult times are unwound and the assets sold back into the market. More broadly, heavy public debt burdens could lead market participants to question the sustainability of fiscal policy. It goes without saying that any such concerns – should they materialise – would have a huge impact on financial markets, weaken financial institutions and cause major damage to the economy.

In sum, high debt levels make the task of bringing inflation under control more challenging. All this deepens the uncertainty that still surrounds the inflation outlook and could restrict central banks' room for policy manoeuvre.

The growth outlook

Moving to the outlook for growth, much of the world has slowed in recent months. Some of the forces which stoked inflation, such as higher commodity prices and supply chain disruptions, have also weighed on growth. Tighter monetary policy has also contributed. But labour markets in general have held up quite well, easing the effect of lower growth on household incomes and consumption.

In the near term, with monetary policy still likely to tighten further, I would expect growth to remain weak. Some countries will probably fall into recession – although such episodes will hopefully be brief and shallow.

But I think the really important question is what happens to growth over the medium term. The global growth drivers of recent decades – globalisation, a stable geopolitical environment and a rapidly expanding China – are unlikely to be so supportive going forward. And fiscal and monetary policy space is much reduced; we cannot rely on these to be the growth drivers of first and last resort.

Ultimately, robust medium-run growth will have to come from more aggregate supply, not aggregate demand. Governments have a role to play in rebooting the structural reform agenda and creating an environment where firms find it profitable and necessary to innovate and invest in productive real assets.  

Assessing the risks of financial turbulence

The current landscape, as I have outlined tonight, highlights the risk of financial turbulence. A key bulwark against this is a sound and well capitalised banking system. Compared with the pre-GFC years, the banking system is in much better shape. However, some non-bank financial institutions are more vulnerable, particularly those with hidden leverage and exposed to liquidity mismatches. The rapid unwinding of pension funds' positions in the United Kingdom in October 2022 is just the latest example. Should turbulence materialise, there will be pressure on central banks to provide backstops and act as market-makers of last resort. But in an environment of high inflation, providing assistance to markets while keeping a tight monetary stance will prove more difficult. Another source of financial turbulence may come from exchange rate gyrations set in motion by the policy tightening and its uneven pace across countries.

The crypto winter

As we have seen, turbulence could also come from an entirely new part of the financial system: the crypto world. This world is largely self-referential. Cryptoassets are not liabilities on any institution's balance sheet and decentralised finance – or DeFi – operates to a large extent without reference to real assets. As crypto activities currently have few real-world uses or none, cryptoasset valuations hinge largely on a constant inflow of new investors who expect prices to appreciate. This speculation is often underpinned by high leverage.

Many of the structural flaws in crypto and DeFi re-emerged with a vengeance in 2022. We have seen investors cut back their inflows into stablecoins and the DeFi space, as well as a drastic collapse in cryptocurrency valuations. Moreover, we have seen some spectacular and high-profile failures, such as the collapse of Terra Luna and the bankruptcy of the then second largest crypto exchange, FTX.  

All that said, the impact of the crypto implosion on financial stability has been quite limited so far. This is thanks to the relative insulation of the traditional financial system from crypto risks due to a conservative regulatory approach. Crypto's limited interconnections with the real world have also helped. Notwithstanding all the headlines about stablecoins, their total value peaked at around $190 billion, less than 1% the size of the US Treasuries market. And with exposures and connections limited, the impact of runs on stablecoins would likely be manageable at this stage. This means that, fortunately, further turbulence in the crypto world is unlikely, by itself, to have an immediate bearing on financial stability.

Yet the crypto winter has forcefully highlighted the urgency of reining in the risks of crypto. Policymakers should act now before the crypto world starts growing again and becomes systemic or undermines the integrity of the monetary system. There are three possible regulatory courses of action, as outlined in a recent BIS Bulletin. To be clear, the dividing lines between the three options are blurry and they are not mutually exclusive. Indeed, they could be applied in combination to effectively rein in the specific risks of crypto.

One choice would be to ban specific crypto activities. This is an extreme option but would probably be difficult to implement in a coordinated way at the international level (as activity would migrate to parts of the world with lax controls). Another option would be to isolate crypto from the traditional financial system through containment. This would entail limiting the flow of funds to and from it by reducing linkages with key financial intermediaries and real-economy players. And the third would be to bring crucial parts of the crypto system under the regulatory umbrella. This could be based on principles similar to those applied to traditional finance. The starting point would be "same activity, same risk, same regulation", ie applying the same regulation and using guiding principles similar to those used in regulating traditional finance and markets to regulate equivalent crypto activities. Each of these options comes with pros and cons: for example, regulation comes with the fundamental challenge of enforcement, not least if international practices diverge.

It's likely that a combination of types of action will be necessary, where different approaches could be applied to specific activities and entities in the crypto space, depending on the perceived risks they pose. A number of initiatives are under way, both domestically and internationally. The Indian G20 presidency has identified crypto regulation as one of its main objectives for 2023; the Financial Stability Board is consulting on principles for cryptoassets and stablecoins; a joint statement on crypto risks was issued earlier this month by US federal bank regulatory agencies, and the EU is also at the forefront with its MiCa regulation. The Basel Committee has also just released standards setting out the prudential treatment of banks' exposures to crypto assets. These initiatives are a significant step in the right direction. But none of these responses so far are ambitious enough to counter the risks to investors and financial stability posed by crypto. More needs to be done.

The crypto industry will undoubtedly resist efforts to constrain its operations. Crypto players have deep pockets and will not shy from attempting to influence the political process to water down regulatory measures. Central banks and regulatory authorities need to ensure that they make efforts to understand and tackle the challenges posed by crypto. It will also be important that regulatory responses to crypto are enforceable.

Central banks can contribute directly by providing trust and better alternatives to crypto that can harness the benefits of technology. A public-private partnership that preserves the two-tier nature of the monetary system could make the system more adaptable, while increasing its efficiency, lowering costs and enhancing financial inclusion. Responses to crypto can take different forms, also depending on specific characteristics of different jurisdictions. These include the introduction of fast payment systems, issuing central bank digital currencies (CBDCs) and, potentially, the support of commercial bank initiatives to tokenise deposits. Scaling on the back of network effects, fast payment systems are well placed to serve the public interest through greater convenience and lower costs, while maintaining the system's integrity.

Many central banks are also considering central bank digital currencies (CBDCs). These have already been introduced in some emerging market economies (EMEs), such as The Bahamas and Eastern Caribbean, where financial inclusion is low and cash distribution is difficult. CBDCs allow new capabilities such as programmability, composability and tokenisation that can be used in smart contracts. But commercial bank money and other assets could also be put into single programmable platforms to be traded atomically, so that transactions are executed automatically when set conditions are met. Tokenised deposit concepts seek to provide the same programmability and functionality of decentralised finance applications.

Conclusion

To sum up, the current circumstances are challenging for central banks. Bringing inflation back to target should be top priority and should be supported by sound fiscal policy.

What does this mean for economic growth? A tighter fiscal and monetary policy stance will weigh on aggregate demand, and the global supply side tailwinds that also helped keep a lid on inflation for the past decades have abated. This highlights the limitations and the risks of relying entirely on monetary and fiscal policy to stimulate domestic growth.

But there is still plenty of room to implement growth-friendly structural reforms which will help economies regain the path of sound and sustainable future growth. These should receive priority when deciding how to allocate limited fiscal resources. In the medium run, stronger and more sustainable growth will also mitigate the debt burdens that otherwise complicate the calibration of monetary policy and its interactions with fiscal policy.

Sustainable growth also hinges on a stable financial and monetary system. A system grounded on central bank money combined with the private initiatives of payment system providers offers a sounder basis for innovation than unregulated crypto initiatives. The BIS is contributing to the creation of the future monetary system by fostering international discussion on the topic, by developing new economic research on innovation and the digital economy, and by developing new technological capabilities in the recently formed BIS Innovation Hub. We are optimistic that technology can be harnessed to find solutions that will be more efficient and more inclusive than those available today.