Shaktikanta
Das
I am delighted to have been invited by
the Nepal Rastra Bank (NRB) to deliver the inaugural Himalaya Shumsher Memorial
Lecture. I deem it as a privilege. I place on record my appreciation of the
Nepal Rastra Bank for initiating this lecture series in honour of Shri Himalaya
Shumsher Rana, the first governor of NRB from1956 to 1961. He contributed
immensely to the development of Nepalese monetary and financial systems. His
efforts laid the foundation for many of Nepal's key financial institutions and
contributed significantly to the country's economic development. Nepal and
India have enjoyed a long standing relationship that goes back into history. It
is not just a relationship between the two countries, it is also a close people
to people relationship. The Nepal Rastra Bank and the Reserve Bank of India
also share a close relationship based on mutual co[1]operation.
2. Central banks have traditionally
functioned as the guardians of macroeconomic and financial stability. In recent
years, central banks were at the forefront protecting their economies and
financial systems from the onslaught of multiple global shocks. They were put
to ultimate test in this extraordinary period of global turbulence and
uncertainties. They had to change gear to revive their COVID-19
pandemic-ravaged economies to waging an all-out war against inflation in quick
succession. Many standard central banking theories and practices were debated;
and while some survived, others had to adapt to the new realities. As we still
transit through this challenging period which is now dominated by geopolitical
conflicts and global geoeconomic fragmentation, it would be appropriate to
examine how central banking has evolved over the years, draw lessons from the
past crises, and prepare for the challenges that lie ahead in the 21st century.
Today, therefore, I have chosen to speak on “Central Banking in the 21st
Century: Changing Paradigm”.
3. I have structured my talk in the
following manner. First, I propose to speak on the established paradigm of
central banking at the turn of the last century. Thereafter, I would like to
describe how this paradigm has evolved, learning from the crisis experiences of
the 21st century, followed by brief remarks on the Reserve Bank’s approach to
policymaking that has helped the Indian economy emerge stronger in the last few
years. Finally, I shall attempt to outline some of the challenges that central
banks will confront in the 21st century.
The
Established Paradigm at the Turn of Last Century
4. By the end of the 20th century, the
theory and practice of central banking had converged to certain core
principles. The first of these core principles was that price stability would
be the primary responsibility of a central bank. This principle had its origin
in the Great Inflation of the 1970s. Subsequently, inflation targeting as a
monetary policy framework gained prominence from the early 1990s, both in
advanced and emerging market economies (EMEs). The second core principle had
its roots in the famous ‘rules versus discretion’ debate in macroeconomics1 of
the 1970s and 1980s, following which a consensus emerged in favour of rules or
constrained discretion in policy making. This was followed by institutional
reforms under which inflation targeting got embedded in rule-based policy
making with some flexibility. The third core principle was about central bank
independence which was considered as critical for achieving the goals of price
and economic stability. While the target was given to the central bank by
elected representatives, the central bank was free to deploy instruments at its
disposal to achieve the given target.2 Central bank independence went hand in
hand with increased accountability and transparency of the monetary policy
decision making process.
Evolving
Paradigm of the 21st Century
5. In the 21st century, the global
economy has gone through a global financial crisis (GFC), a global pandemic, a
global surge in inflation and geopolitical conflicts with global ramifications.
Not too long ago, central banks were fighting deflationary tendencies in the
aftermath of GFC by cutting their policy rates to the zero lower bound and
implementing a heavy dose of quantitative easing. After the onset of the war in
Ukraine, they had to fight against inflation by raising policy rates to
historically high levels.
6. In fact, the eventful first quarter
of the 21st century has provided important lessons for central banks, as it
brings about quite a few changes in the established paradigm of the 20th
century. First, there is now a better recognition of the interconnections
between price stability and financial stability. A key lesson from recent
experience is the need to avoid looking at price and financial stability in
isolation. The linkage from price to financial stability operates in two ways.
First, extended periods of low and stable inflation could lull central banks
into complacency with regard to regulation and supervision of the financial
system as witnessed during the Great Moderation era of 1990s and early 2000s,
germinating the seeds of financial instability. Second, periods of high
inflation that are addressed by strong monetary policy tightening can
jeopardise financial stability if interest rate risks are not adequately
factored in. We saw this in March 2023 when a few banks in some advanced
economies faced sudden stress situations. It is evident that measures for
promoting financial stability can complement or constrain monetary policy
depending upon its usage. Financial stability measures aimed at effective
regulation and supervision of banks, non-banking financial companies (NBFCs)
and markets can enhance monetary transmission and help price stability. On the
other hand, financial stability measures via extraordinary monetary expansion,
if not corrected in time, can risk price stability. It is, therefore, evident
that the relationship between price stability and financial stability runs in
both directions and the impact depends upon the policy choices we make.
7. Second, the 20th century orthodoxy of
central banking was in terms of single objective (price stability) and single
instrument (short-term interest rate). Today, central banks have a broader
mandate of overall macroeconomic stability which includes price stability,
sustained growth and financial stability. Sometimes, the pursuit of price
stability could be in conflict with financial stability as experienced recently
by some advanced economies when tighter monetary policy raised concerns about
the banking system stability. The trade-off between price stability and growth
emergeswhen the pursuit of price stability entails large growth sacrifice. It
is, therefore, important, that central banks employ their multiple instruments,
viz., monetary policy, macroprudential regulation and micro-prudential
supervision in an optimal manner to reduce such trade-offs and achieve better
outcomes for the economy.
8. To best serve all these objectives,
central banks have greatly enhanced their toolbox. In addition to conventional
policy tools, central banks have an enlarged toolbox of unconventional policy
instruments. These include negative interest rates, term lending facilities,
asset purchase programmes and forward guidance. Central banks also rely on
proactive macro-prudential measures to promote systemic stability.
9. Third, central bank communication has
gained prominence as an important policy tool in the 21st century. In older
days, central bankers believed that their communication should be “shrouded in
mystery”, “say as little as possible” and “say cryptically”.4 Those times are
gone. Now, managing expectations through effective communication is a vital
instrument in the monetary policy toolkit. Forward guidance or the absence of
it on the future path of policy interest rates, both state and time based, has
evolved as a new feature to deal with expectations. Central banks have learnt
to build trust and confidence through social media, official speeches, press
releases and public interactions.5 Clear and effective communication and
transparency have played an important role in the success of the inflation
targeting framework.
10. Fourth, recent experience has
underscored the importance of monetary-fiscal coordination for better economic
outcomes. During the pandemic, central banks worked in close coordination with
governments to deal with the unprecedented crisis. Later, when central banks
were battling against multi-decade high inflation, governments took measures on
the supply side to ease inflationary pressures. Consequently, the output
sacrifice needed to bring down inflation was minimised.
11. Fifth, the emerging market economies
(EMEs) have exhibited greater resilience unlike previous episodes. Notably, all
traditional drivers of EME crises of the 20th century were present in the last
few years, 6 but the EMEs have probably learnt from their past experience and
played it well this time. While the resilience of EMEs will be tested in the
face of new challenges cropping up frequently, some lessons can be drawn as
central banks prepare for rest of the 21st century. The foremost lesson is that
strengthening one’s fundamentals is the best buffer against global spill overs
in today’s uncertain world. Fundamentals would include commitment to an
inflation target, maintaining buffers in the form of reserves, and following a
prudent and forward looking approach in financial sector policies. This
approach, together with prudence in fiscal management, will go a long way in enhancing
the resilience of EMEs.
The
Indian Context
12. Let me now turn to the Indian
context. I wish to highlight some aspects of the Reserve Bank’s approach that
have worked well for us. We have not only managed to shield the Indian economy
from multiple shocks in the last few years but have also enabled it to emerge
stronger from the crisis. The Indian economy today demonstrates vastly improved
macroeconomic fundamentals and buffers.
13. Unlike many central banks which are
narrowly focused on price stability using monetary policy, the Reserve Bank has
a wider canvas of functions. It is not just responsible for maintaining price
stability, but also has the larger responsibility of maintaining financial
stability as the regulator and supervisor of banks and other financial sector
entities, financial markets and payment systems.7 This helps us to take a
holistic view of the economy, appreciate the synergy and trade-offs involved in
various objectives, and act appropriately using multiple instruments at our disposal.
14. The Flexible Inflation Targeting
(FIT) framework which got embedded into the law in 2016, established the
primacy of price stability among the objectives of monetary policy, but not
unconditionally. It defined the objective as maintaining price stability, while
keeping in mind the objective of growth. The FIT framework retained the essence
of the earlier multiple indicator approach without any ambiguity about the
hierarchy of objectives. FIT provides flexibility to support growth if the
situation so demands. Financial stability which is a pre-condition for price
stability and sustained growth is thus implicitly embedded as part of the
broader mandate of the Reserve Bank. It is this approach which has helped us to
effectively deal with the multiple challenges in the recent period and address
issues of anchoring price stability, supporting growth and maintaining
financial stability. Details of the specific measures undertaken by the Reserve
Bank are given in a footnote.
New
Challenges for Central Banks in the 21st century
15. Let me now reflect upon some of the
challenges that could significantly impact the central banking landscape in the
21st century. First and foremost, climate change is emerging as a huge
challenge. It can become a systemic risk, if not addressed in time. Severe
climate or weather related events which are becoming more frequent and intense
can impact central bank’s core mandates of price and financial stability by
causing sudden price pressures, damage to infrastructure, loss of economic
activity and stress on fiscal balances. They can also impact the balance sheet
of banks and other lenders. In recent years, there has been a growing role of
regulatory policies in the climate policy toolkit.9 More work needs to be done
in this front while recognising that central banks can supplement the efforts
of governments and other authorities who will be at the forefront of climate
related initiatives.
16. Second, continuing geopolitical
disturbances and geoeconomic fragmentations will pose daunting challenges to
the central banks. Experience of the past few years shows that the journey
ahead may be marked by dynamic shifts in geopolitics, with frequent incidences
of supply chain disruptions and greater barriers in trade, technology and capital
flows. These will be the new sources of shocks, often not well captured in
existing macroeconomic models. It has become important for central banks to
remain vigilant and respond in a nimble, timely and calibrated manner while
navigating such turbulences.
17. Third, technology has permeated
through every aspect of human life. It is bringing about transformational
shifts in the financial services sector. The traditional banking system has
undergone an unprecedented technological transformation over the last decade.
In times of crisis, as during the COVID-19 pandemic, India and a few other
countries were able to leverage digital financial infrastructure (DFI) for
targeted transfer payments. Technology has enabled India to achieve, in less
than a decade, levels of financial inclusion that would have otherwise taken
several decades or more.10 DFI, thus, offers great potential for the future.
18. Fourth, fintech innovations are also
opening up new possibilities. The challenge for central banks in this journey will
be to steer digital innovation towards a more efficient, prudent and stable
financial system, reaping the benefits of DFI while further building on their
track record as trusted safekeepers of price and financial stability.11 Central
banks will also have to deal with issues of regulation and supervision of
digital lenders; observance of fair practices code by the stakeholders; data
security and privacy; and third party service providers, etc.
19. The fifth challenge relates to the
advent of artificial intelligence and machine learning (AI/ML) tools in
financial services. While its application and usage in central banking and
financial services has tremendous scope, it also poses challenges of data
privacy, algorithmic bias and discrimination, cyber security and ethical
issues. 12 Central Banks and other players in the financial services ecosystem
have to enhance their own capacities to deal with these challenges.
20. To sum up, central banks in the 21st
century will have to gear up for all these challenges. While climate change and
geopolitics may work as supply shocks to fuel inflationary pressures and
slowdown global growth and trade; innovation and artificial intelligence, if
well supervised and properly channelised, can help in enhancing productivity and
reducing costs. The net effect will depend, to a great extent, upon central
banks’ own capabilities in harnessing the potential while managing the
transition. This in turn will determine the financial landscape of the 21st
century.
Concluding
Observations
21. Every crisis brings with it new
lessons and ideas. The frontier of knowledge and ideas in economics have
advanced with each crisis in the past. For example, the Great Depression of the
1930s underlined the importance of fiscal and demand management policies; the
Great Inflation of the 1970s brought to focus the need for credibility and
consistency in policy frameworks; the global financial crisis of 2008
underscored that financial stability can not be separated from overall
macroeconomic stability; and now the sequence of unprecedented shocks since the
pandemic have driven home the need for policymakers to be agile, proactive,
innovative and prudent in their policy responses, without being constrained by
orthodoxies or dogmas. Thus, economic theory and policies have evolved over the
years with experience gained and lessons learnt from each crisis. In fact, this
has indeed been the story of central banks over the years.
22. With several crisis of global
proportion occurring in quick succession in the last few years, central banking
theory and practice are undergoing subtle and sometimes significant changes. At
the Reserve Bank of India, our effort has been to pursue proactive and prudent
policies so that the Indian economy evolves along a sustainable growth path. I
am glad that our efforts have yielded positive outcomes. The Indian economy has
rebounded strongly from the pandemic and is contributing more than 18 per cent
to the global growth. Inflation is on a declining trajectory. External sector
remains resilient with strong buffers. The health of banking and corporate
sectors remains strong. Fiscal consolidation is under way.
23. As preeminent macro-financial policy
institutions, central banks have to keep reinventing themselves in tune with
the times. They have to anticipate future risks and undertake suitable
pre-emptive measures to avert or mitigate potential risks, if any. I am
confident, the central banks will rise to the occasion and lead from the front
to safeguard their financial systems and economies from the emerging challenges
of the 21st century.
Thank you. Namaskar.
Shri
Shaktikanta Das is Governor at Reserve Bank of India
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