Central banks play a crucial role in ensuring economic and financial stability. They conduct monetary policy to achieve low and stable inflation.
In the wake of the global financial crisis, central banks have broadened their tools to deal with risks to financial stability and manage exchange rate volatility.
In response to the COVID-19 pandemic, central banks have used an array of conventional and unconventional tools to ease monetary policy, support liquidity in major financial markets, and maintain the flow of credit.
Central banks need clear policy frameworks to achieve their goals. Operational processes adapted to the circumstances of each country enhance the effectiveness of central bank policies. The IMF supports countries around the world by providing policy advice and technical assistance.
A key role of central banks is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations. The policy frameworks in which central banks operate have undergone major changes in recent decades.
Since the late 1980s, inflation targeting has become the main framework for monetary policy. Central banks in Canada, the eurozone, the UK, New Zealand and elsewhere have introduced an explicit inflation target. Many low-income countries are also moving from targeting a monetary aggregate (a measure of the volume of money in circulation) to an inflation targeting framework. More recently, with growing concerns about the erosion of policy space amid lower equilibrium interest rates and falling inflation expectations, the major banks Central authorities have revised their monetary policy frameworks.
Central banks conduct monetary policy by adjusting the money supply, usually through open market operations. For example, a central bank may reduce the amount of money by selling government bonds under a “sell and buy” agreement, thereby taking money from commercial banks.
The purpose of these open market operations is to steer short-term interest rates, which in turn influence long-term rates and overall economic activity. In many countries, especially low-income countries, the monetary transmission mechanism is not as efficient as in advanced economies.
Before moving from currency targeting to inflation targeting, countries should develop a framework for the central bank to target short-term interest rates.
In the aftermath of the global financial crisis, central banks in advanced economies relaxed their monetary policy by cutting interest rates until short-term rates were close to zero, which limited the possibility of reducing more policy rates (i.e. limited conventional money market options).
Faced with the risk of growing deflation, central banks have engaged in unconventional monetary policies, notably by purchasing long-term bonds (particularly in the United States, the United Kingdom, the euro area and Japan) with the aim of continue to cut long-term rates and ease conditions. Some central banks have even taken short-term rates below zero.
In response to the COVID-19 pandemic, central banks have taken unprecedented policy measures to ease monetary policy across the world, provide abundant liquidity to core funding markets, and maintain the flow of credit.
To ease tensions in the local currency and bond markets, many central banks in emerging markets have resorted to currency intervention and rolled out asset purchase programs for the first time.
Exchange rate regimes and policies
The choice of a monetary framework is closely linked to the choice of an exchange rate regime. A country that adopts a fixed exchange rate and allows free movement of capital will have limited leeway for independent monetary policy compared to a country that has a more flexible exchange rate.
Although some countries do not fix the exchange rate, they still try to manage its level, which could involve arbitrage with the objective of price stability. A fully flexible exchange rate regime supports an effective inflation targeting framework.
The global financial crisis has shown that countries must contain the risks to the financial system as a whole with dedicated financial policies. Many central banks that also have a mandate to promote financial stability have improved their financial stability functions, including by establishing macroprudential policy frameworks.
Macroprudential policy needs a solid institutional base to function effectively. Central banks are well placed to conduct macroprudential policy because they have the capacity to analyze systemic risk. In addition, they are often relatively independent and autonomous. In many countries, lawmakers have given the macroprudential mandate to the central bank or a dedicated committee within the central bank.
Whatever model is used to implement macroprudential policy, the institutional framework must be strong enough to counter financial industry opposition and political pressures and to establish the legitimacy and accountability of macroprudential policy.
It should ensure that policymakers are given clear objectives and the necessary legal powers, and encourage cooperation from other supervisory and regulatory agencies.
A dedicated policy process is needed to operationalize this new policy function, mapping a systemic vulnerability analysis into macroprudential policy action.
In response to the COVID-19 pandemic, many countries have relaxed macroprudential buffers to complement other policies in an attempt to absorb tensions in the financial system and support lending to the economy. Such a policy can be consistent with the existing IMF framework.
How the IMF supports effective central bank frameworks
The IMF promotes effective central bank frameworks through multilateral surveillance, policy papers and research, bilateral dialogue with its member countries, and data collection for policy analysis and research. research.
Multilateral surveillance, policy analysis and research can help improve global outcomes:
The IMF has provided advice on how to avoid the potential side effects of implementing and exiting unconventional monetary policy, and established principles for the evolution of monetary policy regimes in developing countries. low income. IMF