The Past, Present, and Contested Future of Central Banks

The Rhodes Center Podcast explores the most important issues in finance and economics through straightforward, candid conversations with the world’s leading experts. The show is hosted by Mark Blyth, political economist and Director of the Rhodes Center, at the Watson Institute at Brown University. 

On this episode Mark talks with Manuela Moschella about the recent transformations to central bank policy and orthodoxy. Central banking used to be straightforward - fix short term rates and get price stability. 2008 changed that. Engineering asset price instability and massive bailouts became the norm and, despite all that, deflation, not inflation became the problem. The Fed and the ECB were late in waking up to that fact, and just when they did, COVID hit and inflation came back. So Mark asks Manuela: what is a central banker to do? 

Manuela is an Associate Professor of International Political Economy at the Scuola Normale Superiore and Associate Fellow at the Europe Programme at Chatham House. 

Watch Manuela’s talk at the Rhodes Center

Learn more about the Watson Institute’s other podcasts


MARK BLYTH: Welcome to the Rhodes Center Podcast. I'm Mark Blyth, the director of the Rhodes Center for International Economics and Finance at Brown University. Central bank and is one of those things that simultaneously predicated upon communication while being totally opaque to most people. It relies on signals being transmitted to an audience to make policy work but it's not really clear who the audience is.

For example, a recent paper on New Zealand where they've had inflation targeting for four years concluded that New Zealand businesses were several thousand times more likely to share pet videos than inflation forecasts. Nonetheless, central bankers take the reputation and communication strategies very seriously. So what is it they want to communicate so credibly? That used to be easy.

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But then the world changed. After the Great Financial Crisis Two-Thousand-Eight, deflation, falling prices became the economic problem to solve rather than inflation, especially in Europe. To do so, central bankers reinterpreted their mandates. No making price instability via massive quantitative easing and other programs, their new objective. This rather obviously run against the reputational capital all the things that they'd said and why they were doing over the past 30 years.

Doing so stabilized the system but also brought about a new interdependence between financial markets and central banks where the goal used to be to take away the punch bowl just as the party was getting started as Fed Chair McChesney Martin said back in the '50s, the job after Two-Thousand-Eight seemed to be increasingly keep filling up the punch Bowl so that asset prices in too big to fail banks don't crash. That's a very, very different set of policies and it's got to hurt your reputation.

Central banks also began to take a broader view of financial risk given these new mandates and soon began to encroach into areas such as targeted lending and Greening financial policy. And then came COVID with ever greater financial support for asset prices once again to stave off instability. After years of rethinking their mandate and thinking that inflation maybe wasn't the big problem after all, inflation came back.

You would think that this would allow central banks to simply pivot back to the old script and forget about that whole messy Two-Thousand-Eight onwards period, but reputations matter, they're stickered. Having disavowed inflation risk for deflation fighting it's not so easy to go back even when inflation comes back. Again, reputations matter.

Someone who's thought an awful lot about the effects of reputation and politics, particularly in Central banking is Manuela Moschella. She's an associate professor of International political economy at the Scuola Normale Superiore in Florence and we decided to have a chat about central banks past, present and future. I hope you enjoy it.

Manuela, welcome to the Rhodes Center Podcast.

MANUELA MOSCHELLE: Thanks for having me, Mark.

MARK BLYTH: So it was a really great shot that we had today live and we always like to follow this up with a podcast. So for the benefit of folks who didn't catch the live chat, which I'm pretty sure you can actually get on YouTube and you can watch anytime if you want to, let's just break this down to basics. We're talking about central banks. We're talking about central banks in the current moment having a kind of a difficult time in comparison to where there have been before, let's go back to basics.

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So by controlling short term interest rates, the central banks would have sent a general signal to the economy about whether the economy should pump up or kind of slow down a bit and so really kind of steer the economy from the distance. And so price stability plus interest rate policy became what central bank independence is ultimately about.

And I think we should concede that it worked extremely well. I think it kind of work magic, right? If we think in hindsight, central banks really managed to reduce inflation volatility, they became the kings or probably the queens of macroeconomic stability. And so it endured for over three decades, but then we had the crisis period.

MARK BLYTH: OK, let's hold it there rather than run on. So Volcker, Paul Volcker, he controls inflation by essentially rationing bank reserves. That makes the price of money borrowing money really expensive and overnight interest rates in the US went up to 16%, for an extended period caused a huge recession and then brought down inflation. England followed suit, Bank of England pushed up rates, everybody pushed up rates, and that kind of ended the Great inflation.

But as well as having this control of interest rates, there's also this philosophy built into that period of these being conservative central bankers. No, we don't mean that they care about local control school boards and Jesus, we mean that basically conservative has a particular meaning in Central banking. Can you unpack that for us?

MANUELA MOSCHELLE: Oh, absolutely. Conservative means that the objective of a central bank should be really that to prioritize price stability on top of any other objective. As you nicely put it, Mark, in kind of summarizing what happened with the so-called Volcker shock, basically I mean, the interest rate rise and the control of inflation came at a cost. It came at the cost of employment. I mean, it was a severe economic recession what happened.

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RK BLYTH: So let's unpack the:

And it's a weird thing because on the one hand, these are supposedly delegated institutions, whether in a democracy, therefore at the end of the day, the principles are still meant to be in some mediated chain the voters. But we want them to be independent of our political delegates, the people that we send to parliament. How does central bank square the circle of being independent undemocratic?

MANUELA MOSCHELLE: That's a very difficult choice and I'm not sure whether they squared that circle nicely. So the independence of a central bank. So they receive the Democratic mandate to achieve price stability, it's where democracy lies. I mean, that they received a mandate really to prioritize price stability over any other objective because the reasoning was that once we are able to stabilize prices, everything will go right. I mean, it creates the precondition for productivity to grow, it creates the conditions for the economy to grow. So that was the line of reasoning, is that kind of price stability creates the precondition for economic growth. So the mandate came from the political sphere, right? It came from the public, the public supported it, the political class supported it, and so that's where democracy comes from.

But then of course, I mean, the relationship between independent agency and politics is very much complicated. And also because in the past 30 years, the idea of independence has been shaped, again, in a peculiar way. It has taken a particular connotation. Independence has also meant a very strong indication that the central banks should act against the wills of elected government.

So no matter what, the so-called monetary dominance, so that it needs taking its decision, an independent central bank should really defy governments financing needs. And this is a huge plank of central bank independence before the recent crisis. So it was really part and parcel of this concept of central bank independence because again, I mean, central bank independence can take different forms, different interpretations over time but the one that became dominant was really one that insulated central banks from any type, at least allegedly, from political pressure.

MARK BLYTH: So that monetary dominance as you put it really is a kind of political dominance. That is to say, it doesn't really matter what Italian voters think they want, the central bankers know better. They have the true model of the economy, they know whether you can really afford things or not.

So whether people vote for policy x or policy y doesn't matter, what matters is the feasible policy, say, as adjudicated by central bankers. Now this goes to this whole notion that you have developed in your work about reputation. Tell us why you think reputation is both central to fulfilling that mission and also something that causes them problems.

MANUELA MOSCHELLE: Absolutely. I mean, central banks are public institutions. And as any public institutions, they have to justify and legitimize both their powers and independence. And of course, I mean, one way to justify it is by their policy performance, right? But another important and probably an underappreciated channel is reputation, right? They build a really clear organizational image about them, they project and stick to it in their policy, because in this way, external audiences, whether they are financial markets, policy makers, citizens, can recognize what a central bank is about.

And so they have really invested a lot in the past three decades in forging this image that we have already mentioned. One of the faces of central bank's reputation over the past three decades that has been conservative needs. So they have really projected this image of central banks as the guardians of price stability.

The other I think key tenets of central bank's reputation have been this image of neutral institution that is very much related to the interest rate policy they ordinarily command. That is to say they have said, look, we do not really get enmeshed with distributive political decisions. I mean, we send a signal by steering the economy through interest rate rise or bringing them down and it is a general input. It applies to everybody, it applies to me, it applies to Mark, it applies to the owners of the firm over there and that's the reason why they carved this image.

Now the problem is that when external circumstances or the audience sees that to which the central banks speak to get this content, right? And I think this is what happened during the recent crisis period first with Two-Thousand-Eight and then with the Twenty-Twenty, political monetary policy get a lot of political visibility. And the public started being concerned about the role of central banks, both in the run up to the crisis. I mean, think about the States. I mean, the Fed has often been blamed for having caused the crisis, for having been asleep at the wheel while financial markets were brewing but the same goes in Europe.

And so in order to move beyond the reputation in the past, they ultimately need political support. And I think it's also something if I made it we saw back with the Volcker shock. Of course, I'm not an historian here but I mean there are many interesting historical accounts of the Volcker era that show that of course Volcker personality and leadership was crucial but what was also crucially in the Volcker era was that he finally gathered political support to control inflation, both in the public and in Congress, right? Because otherwise it probably would have been impossible.

MARK BLYTH: So let's jump from that crisis into the one that we've been kind of signaling towards. This begins to change in Two-Thousand-Eight. You have this world of conservative central bankers, you have reputation, you have signaling, we have this wonderful period, the Bernanke the ex Fed chief called the great moderation, whereby price volatility and interest rates were low and growth was relatively high.

So everything was going great. They'd been on watch, things had been great under their watch, QED they caused it, we can come back to that whether they did or not that's actually more of an open question, I think. But regardless, that's the way that it happens. Then along comes Two-Thousand-Eight.

Leverage in the banking system becomes exposed and the central bank suddenly have to do something very different that has cause massive price instability in credit aggregates and liquidity under the price of assets in order to stave off a total collapse. How does that feature into this armory of credibility that they have that you see as being so central to what they do? Why does the success of Two-Thousand-Eight become the problem they have to face later on?

MANUELA MOSCHELLE: I think this is a fascinating part of what happened, right? So the central banks ultimately moved away from their monetary orthodoxy and the orthodoxy they have contributed building. And as you said, they entered into these really unfamiliar terrain in which they have to provide credit to particular institutions, to the governments, in Europe to particular countries other than others. So they enter in these very tricky terrain.

And as compared to the previous tidy causey world of central banking, the setup, which was extremely necessary to confront the crisis, was not that successful in the end, right? If we think about it in hindsight just before COVID crisis started in Twenty-Twenty the buzzword in policy circles was secular stagnation. And what does secular stagnation points about was that basically the monetary accommodation that has been enacted since Two-Thousand-Eight was a failure. Why was it the case? Because economic recovery was still anemic many years since the start of the global financial crisis.

Yes, probably pre-crisis GDP level has return, have been surpassed, but few high income countries have really return to economic growth of a decent size. Also, inflation risks were clearly on the downside, right? If we look at the long run of inflation, initially, central banks managed to stabilize inflation at the height of the global financial crisis but then inflation started falling across the board. Already in Twenty-Twelve it was well beyond the so-called 2% target. And it has remained so low even before COVID.

And on top of that, I mean, what you also mentioned Mark, in terms of why it was not successful. The monetary accommodation that central banks provided is that it is fueled a lot of inequality because one of the biggest side effects of these unconventional policies of central banks interventions in the market, again, they were necessary. We have to admit that. But one of the biggest side effect was increasing inequality, because it basically shore up asset prices and so who benefited the most were those that held assets, the most lucrative assets.

So this was one of the biggest failure. And the situation was not bright for central banks even after several years of monetary easing, even if they are kind of broken up with orthodoxy so much so that I mean, they were talking about secular stagnation. They were also concerned that if another economic shock would have arrived, they would not have had the ammunition because the policy space was so low to intervene should economic being hit by another shock. And that's the irony now that's the COVID case. The COVID crisis came in, it was completely unexpected. So that's exactly what happened. But it was an extremely difficult situation for central banks.

MARK BLYTH: But before we get to COVID, let's go to that period after the austerity binge in Europe when they're still in Two-Thousand-Eleven. Trichet, the central bank chief, is raising interest rates into the teeth of a deflation and talk more about what your work is also talked about, which is the politics of central bank and the policies of a central bank operating in an inflation and deflation are not the same thing.

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You can do all this quantitative easing and cutting rates to zero but then you're kind of pushing on that proverbial piece of string to get the economy moving. Around that time as well as then all this stuff, certain central banks, particularly the British central bank, began to get concerned with the greening of the economy.

That is to say that central banks started to take on a broader view of systemic risk, thinking not just about too big to fail institutions but about the financial sector promoting and investing in the types of assets which are heavy carbon assets, which are particularly problematic if you want to go through a green transition. So they took that onto their mandate and that was in no way anything to do with the Volcker script. So where did that come from and how do you see that fitting into the story of central banks?

MANUELA MOSCHELLE: I think that, as you said, it was a huge expansion of their mandate, especially as compared to what we said as the benchmark, the Paul Volcker year, right? It was really clear that the objective was so narrow, it was price stability. Then I mean, they started expanding and expanding. With the Two-Thousand-Eight it was financial stability, it was tackling unemployment. I think interestingly, central banks were aware that they were expanding this mandate. Indeed, they used to call these other objectives of intermediate objectives to signal that they were not entirely deviating from the price stability objective but they in order to get there they have to first of all address the problem in financial markets, they have to address the problem in the labor market.

The problem is that I think that the sequence is important, right? The moment you enlarge, the moment you create expectations, right? And I think this is what happens with the public that then the public starts to expect more from a central bank. They expect more support, financial markets expect more support. And so then pulling the plug becomes even riskier from the perspective of central banks because then they risk to be blamed.

And I think it's where they are right at the moment. They are in an awful position because now that inflation is back on the radar screen, they risk really to be blamed one way or the other. They are blamed for inflation that is running hot, they are risk to be blamed if they raise rates and they really create a recessionary environment once again, and they will be the easy scapegoat to find.

MARK BLYTH: Along side of this at the same time because it's such an interesting period of history we've just lived through and we don't often unpack it in this way so I'm enjoying this opportunity to do so with you. As well as the greening of central banks, there was the rethinking of inflation.

And it started first arguably with the Bank of England and then it was actually the European Central Bank then the Fed. The Fed acted on it first with its kind of policy review framework, and then the ECB pivot in the same direction, all of which basically said, actually lads, inflation's nowhere to be seen for 30 years, the big problem is deflation. We should be honest about this, we've been doing stuff, it's probably more harmful than good in some instances but it was the only toolkit we had. So maybe we need a rethink inflation has been the number one problem we have to face.

Now I'm putting that out there because I want you to now talk about COVID. Because when COVID hits, basically the central banks reach back to the Two-Thousand-Eight playbook and then go for it again only in overdrive. So how did that look from the point of view of what was going on at the Fed and the ECB?

MANUELA MOSCHELLE: The point I want to make is that I completely agree. When the COVID strikes, central banks really went back to the playbook they used back in Two-Thousand-Eight and Twenty-Ten. But even more so, they have been much more aggressive this time around. We have to recognize them also because I mean they had the experience, they have learned from the past, but I think here interestingly what really makes the difference and it speaks to this idea that central banks need government support is that fiscal policy was much more supportive this time around, both in the United States and in Europe.

You were mentioning austerity before. Of course, I mean, what happened in Europe this time around was completely different in Twenty-Twenty than what happened in Twenty-Ten. It was entirely clear that fiscal policy should be supportive as much as monetary policy is, and again, I think that this is crucial also to understand the extent to which monetary policy was so supportive in the wake of the COVID crisis.

Yes, they had learned from the past, from the recent past, so they were prepared, right? They could easily replicate the policy scripts they've used in Two-Thousand-Eight and Twenty-Ten but at the same time, this time around, government support and coordination with the government was clearly forthcoming, right? So they knew that even if they were crossing red line in traditional central banking, they were doing alongside their domestic governments.

You were mentioning the reviews, I think is extremely interesting, right? Because they really arrived just before the inflation came back, right? And it was a welcome redressing of the inflation mandate, right? It was a welcome I think rethink of the way in which central banks have to navigate and balance the trade off between inflation and employment. So they really tried to redress and probably make up also for some of the mistakes of the past. But interestingly, it came really just before inflation came back onto the radar screen. So it's really probably now it's testing what central banks will do also in light of the reviews that the recently adopted.

MARK BLYTH: So one of the stories I had locally about why the Fed made the policy shift and that was the Fed started to organize, I think this is when Claudia Sahm was there. A bunch of community meetings with ordinary people called Fed listens. And then several of these meetings, the Fed Chair Powell would go into this room and sort of say, we are having trouble kind of getting our message across regarding our mandate, and price stability and all this.

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So this is how this inflation mandate, inflation targeting regime begins to change and attenuate. But let's go back to your point about reputation and recap, right? So central banks used to be dependent, they weren't independent. And we made them independent in the wake of the Volcker shock because that showed that when they were independent, they could control inflation.

So they make a whole thing about and controlling inflation and there's no inflation for 30 years. There's no inflation anywhere for 30 years so it's really not clear to me that they were the ones who really controlled it, it was gone. It was a one time deal, interest rates went down and inflation rates went down.

And now we get to Two-Thousand-Eight and then they basically violate everything that they've said so far and do the exact opposite by causing massive price instability. They then start to get into the green taxonomy, they're doing targeted lending. They're dragged into these various aspects of distributive politics. And then they think, yeah, you know what, maybe we should just fess up and say that inflation isn't that big a problem. COVID comes along. Like you said, the reach back to the playbook, they do Two-Thousand-Eight all over again times two. And then inflation shows up. What's that doing to reputation at this point?

MANUELA MOSCHELLE: I think it's really fascinating what happened because I think that central banks have really tried to adapt and change without completely disrupting their reputation. They have tried to maintain kind of a core, right? But as I was saying before, once they open up the mandate, once they say, we care about unemployment, once they say, we care about the environment. And I mean, we will fight for decarbonize the economy, inevitably, they touch back on their reputation.

So for me, it's where reputation is biting again. Today we are all fixated on central banks responses to inflation, right? How quickly they will raise rates but let's stop for a second. I think that they have been extremely cautious thus far as compared to historical standards when they would have probably reacted in a quicker manner. I mean, you were remembering Tricia Two-Thousand-Eleven when they raise rates in the middle of a recession.

So I think that it is a sign that the reputation has changed or at least they are aware as you were saying that the public is concerned about wage growth, and employment, and stuff like that. So they keep an eye and they keep an ear on those developments. For me what is astonishing is that they have not reacted before. So that up to now, they have made the case that inflation is transitory because it depends on global supply chains, because it's pent up demand after the pandemic.

Of course now the situation is probably changing because the labor market is probably coming tight, probably in the United States. But to go back to your question about reputation and politics, what I really think is that as compared to other episodes in the past where central banks retreated from monetary accommodation much more quickly at the first sign of inflation, here they balked a little. And the reason they balked is that because they changed public expectations and they have changed a little bit the reputation.

MARK BLYTH: This also because in part they've changed their minds as well. And this is an interesting thing that goes back to your talk today. Not to push it's like just an idea story but you have a really interesting way of putting this. You said that central banking is an institution and the technology they use is interest rates. And I think that's absolutely great as a description and it makes me wonder whether the technology is kind of regime dependent to use a fancy phrase.

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So it's not clear to me now that this technology of the '70s, just moving short term interest rates up and down, it's actually going to do anything to solve the inflationary problems that we have. And if that's the case, what does that do to the reputation of central banks now? What if they lack the technology to solve the problem that they themselves say they are uniquely qualified to solve? Where does that leave us?

MANUELA MOSCHELLE: Absolutely. I think that central banks are in an awful position probably because as you rightly said, they do not have the right technology for it, let's face it. And also central bankers at least at the beginning when inflation was starting to go up, they recognized that. They've always said, an interest rate rise won't make new trees to grow, right? An interest rate rise won't solve global supply chains disruption, right? At the beginning, I mean, they try to get this message across. So they really recognize that the interest rate technology would be too blunt of an instrument under these circumstances.

I don't know what would be the ideal technology but I have a parallel in mind with financial stability, especially back in Two-Thousand-Eight and Twenty-Ten there was a similar discussion. Interest rates are not the most appropriate technology to deal with financial market instability and that's where macroprudential regulation came about. So we should regulate not just at the micro level but also looking at the interaction in financial markets as a whole.

Probably we need something else right now. So something akin to the macroprudential turn that took place around the Twenty-Ten but if not, I'm back to what I was saying before. I think that central banks are facing a lose-lose situation, right? Because if they use the interest rates to control inflation, the risk is a Volcker recession, right? And if the Volcker recession materializes, they will be blamed. In Europe it also comes with a twist because raising interest rates could destabilize sovereign debt markets. I'm Italian, I don't want to even think about what's going to happen to the Italian market should the ECB mismanage a potential interest rate rise, right?

On the other hand, and it's the lose-lose situation, if they do not control inflation, and if inflation expectations get out of control, even if rationally we all know that it's the lumber and it's the climate change but we all know that expectations do not respond exactly to material reality. So if they get inflation out of control, they still will be blamed, politically I mean.

MARK BLYTH: And if they don't get it under control because it's not monetary causes and we expect them to do it, there's a different type of overreach which is going to affect their reputation, which is, you said you guys could give us price stability. Well, you can't. And if they turn around and say, yeah, that's because what we used to be able to make prices stable no longer works, it's a whole different set of causes, that really delegitimates the special status that we've given these institutions as being the primary policy making locus of economic policy. Where do they go from there because in a sense they would be shorting their own futures?

MANUELA MOSCHELLE: In the months, in the weeks ahead. Honestly, I mean, I think that being a central banker these days is going to be really a headache. At the same time, I think what is really crucial is what you said. It's the expectations that are placed on central bankers. There is a nice quote from former Bank of England Governor Mervyn King just before he stepped down as governor at the Bank of England. And he said, reflecting on his experience at the Bank of England, "We arrive at a moment in time when too much is expected from us," right? And us is central banks.

Because he recognized this trend, he recognized how the policies that they have implemented to respond to the circumstances, to respond to the political environment create new expectations. And the real question is, can central banks meet these expectations? Are they really positioned? Are they the institution that should respond to these challenges? And this I think goes to really a democratic politics question, a very important democratic politics question.

So should society entrust central banks to perform this function? Because probably, I mean, we haven't fully considered the implication or probably means should be treasuries to take care about decarbonizing the economies, right? Or at least saying that in the era of climate change, central banks are not independent as they are in monetary policy. A more variable geometry type of central bank independence that varies according to the issue area.

MARK BLYTH: But exactly as your work would suggest, that's going to be really difficult if your entire claim to fame is based upon past reputation.

MANUELA MOSCHELLE: That's right, that's right. Although I think it's changing. But it's not clear exactly in what direction but absolutely. If you cling to your past reputation, if you want to adapt but at the same time rescue the past, I mean, you really risk to be crashed on the rocks, I think.

MARK BLYTH: That's a disturbing but nonetheless great place to leave it. Manuela Moschella, thank you very much.


MARK BLYTH: This episode was produced by Dan Richards and Kate Daario, I'm Mark Blyth. You can listen to more conversations like this by subscribing to the Rhodes Center Podcast wherever you listen to podcasts. We'll be back soon with another episode of The Rhodes Center Podcast. Thanks.


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The Rhodes Center Podcast with Mark Blyth
A podcast from the Rhodes Center, hosted by political economist Mark Blyth.

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