Central bank dilemma: no easy answers for a new set of economic challenges

Natixis CIB hosted the first edition of its Global Macro Conference in London, bringing together more than 200 clients and asset management industry professionals at the Langham Hotel.

Alain Durré, Chief European Economist at Natixis CIB, sat down for a discussion with Klaas Knot, former President of De Nederlandsche Bank and Chair of the Financial Stability Board, and Athanasios Orphanides, MIT Professor, former member of the ECB Governing Council, and former Senior Advisor at the Federal Reserve Board. Their discussion explored the policy strategies best suited to addressing the high-rate environment in developed economies.

Both the US and EU face a number of overlapping economic challenges: sustained inflationary pressure, global conflict, uncertain trade relations, fiscal strain from rising debt-to-GDP ratios, and higher long-term bond yields. Meanwhile, ageing populations are increasing pressure on public finances, while investment in technology is driving more borrowing in the private sector.

This has made monetary policy more difficult. Quantitative easing can ease pressure on bond markets but risks fuelling inflation, while higher interest rates make borrowing more costly. The challenge is balancing price stability with economic growth and financial stability. Central banks must reconsider the priorities of their mandates and the economic tools they use to assess market conditions and guide policy. This can help them design interventions that consolidate debt and curb inflation without undermining financial stability.

Central banks have defined goals and mandates. In turn, the hierarchy of these mandates is central to how policymakers act. Following the global financial crisis, central banks expanded their responsibilities beyond price stability and maximum employment to include broader financial stability objectives. These measures were designed to address weak demand and low inflation. However, the frameworks developed during this period may be ill-equipped to manage today’s economic challenges, which are increasingly driven by supply-side shocks. The speakers identified how this approach to central banking “from above” – through quantitative easing designed to stimulate inflation – fundamentally differs from the current “from below” approach which aims to curb inflation.

The way the ECB and the Fed shift their mandates to prioritise price stability is determined by the legal mechanisms that established them. The ECB explicitly identifies price stability as the primary mandate in the Maastricht Treaty. By contrast, the Fed’s dual mandate has no such hierarchy, meaning its application is shaped by the Chair's and the FOMC's interpretations. Current Chair Kevin Warsh’s move away from his predecessor, de-emphasising maximum employment in policy statements, reflects a shift in the implicit mandate hierarchy.

Narrowing mandates to price stability is a reaction to years of above-target inflation caused by successive economic shocks – from the Covid pandemic to the energy supply shocks of the Russian invasion and the Iran war. The series of fiscal interventions to cushion the impact have created historically high debt-to-GDP ratios in both the US and EU. A lack of political will for consolidation of public spending is resulting in the re-pricing of fiscal risk – which the speakers point out – is an important factor in the run-up of long-term bond yields.

Despite higher borrowing costs, the appetite for borrowing continues to grow.  Ageing populations are adding to pressure on public debt, while the rapid build-out of AI infrastructure is driving a boom in private-sector borrowing.

The discussion expanded to how the challenging rates environment is also a product of the bond term structure. Reliance on the R* – a theoretical metric of the neutral interest rate – delayed policy tightening, contributing to continued inflation. Speakers agreed that the estimate deviations make R* a weak econometric tool, citing John H. Williams’ famous phrase that its effect, like faith, is seen by its works. Meanwhile, long-term premia distorted bond yields, which were artificially compressed through quantitative easing programmes, meaning the move to reducing balance sheets triggered a rapid repricing. Speakers agreed that policy decisions must avoid over-relying on these unobservable metrics and instead prioritise market data.

Price stability and market data should remain central to monetary policy, but this does not mean central banks can retreat from financial stability. The two are closely linked: financial instability can disrupt the transmission of monetary policy. The ECB’s July 2011 rate hike, which was later reversed to avoid destabilising the financial system, illustrates the risks of focusing narrowly on price stability without accounting for the liquidity mechanisms that help monetary policy curb inflation.

On the other hand, central bank mandates must avoid the risk of overstepping their mandate. Speakers agreed that the ECB’s participation in Troika programmes (in the context of the euro area sovereign debt crisis), despite being a reaction to a lack of crisis-response tools, posed a risk of entangling monetary and fiscal policy. This creates a serious moral hazard given that central banks are not elected institutions. Dedicated crisis tools, such as the European Stability Mechanism, should enable the ECB to continue extricating itself from the political role it assumed after the global financial crisis.

In the US, the Fed faces an independence risk from the perceived politicisation of appointments and rate-setting decisions, drawing fears of fiscal dominance, whereby central banks monetise debt. The speakers agreed that this risk exists but remain confident that democratic mechanisms continue to mitigate it.  Markets punish the degraded fiscal credibility of a passive central bank through inflation expectations, which, in turn, cause higher prices for voters. Even in the short term, the resulting economic pressure can have significant political consequences, potentially contributing to electoral defeats.

Aside from political and moral considerations, central bank independence lowers disinflation costs, as seen in the discussion’s comparison of how supply shocks played out before and after independence was established. The 1970s oil supply shock unanchored public and market inflation expectations because central banks lacked institutional independence and, therefore, credibility. This led Fed Chair Paul Volcker to intervene by inducing a recession, causing extensive damage to the real economy. By comparison, independence meant inflation expectations remained anchored during the supply shocks of the 2020s, with the economic impact largely contained to a slowdown in growth.

The panel reached a consensus that the approach to address the current high-rate environment must lean on the strength of institutional independence and financial stability tools while refining policy frameworks and set out a path to reduce balance sheets in the long term.

Speakers discussed using short-term inflation projections more prominently, allowing central banks to adjust rates incrementally each quarter. They also called for a more prudent approach to intervention tools. One option is to reform collateral frameworks by ending their reliance on private US credit agencies. This approach helped contain euro-area spread volatility in April 2020 and is simpler than implementing existing interventions, which can involve challenging legal requirements.

Over the longer term, policy strategy must work to restore balance sheet efficiency through quantitative tightening. As balance sheets shrink, the term premium can move towards a historical equilibrium, restoring market pricing across the yield curve. This strategy reduces the need to tighten policy interest rates at the short end and allows central banks to exit excess-liquidity systems and return to traditional corridor operating systems. The speakers concluded that a 10% to 20% GDP target should be gradually achieved over the next 10-20 years for the balance sheets; however, maintaining this trajectory will depend on strong central bank leadership.

The discussion made it clear that a path out of the current dilemma requires a multi-faceted strategy. This means rethinking traditional economic models, placing greater emphasis on market-based inflation indicators and reconsidering central bank mandates that were shaped by the low-inflation environment following the global financial crisis.

Prioritising price stability will require trade-offs at the long end of the bond curve, as quantitative tightening drives up yields, but will allow for less short-term rate tightening, reducing the cost of disinflation. Although this strategy affects governments' fiscal outlook by raising borrowing costs, the need to re-protect price stability must take precedence over secondary mandates. Existing measures to ensure financial stability and mechanisms to safeguard central bank independence can provide a foundation for the successful transmission of monetary policy.