Redefining Central Banking

• Author: Duvvuri Subbarao
• Position: Governor of the Reserve Bank of India.

CENTRAL banks have been at the heart of the global financial crisis. They have been blamed for policies and actions that got the world into the crisis; they have been praised for leading the world out of it. Both are fair assessments. Central banks have been a part of the problem and a part of the solution.

As the crisis unwinds and recovery takes hold, central banks face a number of issues, of which I will address five.

Monetary policy in a globalizing environment

The crisis has demonstrated the difficulties of macroeconomic management in a globalizing world. Even as governments and central banks acted with an unusual show of policy force, they were unable to get the situation under control because of the interconnectedness of the financial system and the effects, positive and negative, of external developments on domestic policy actions. Most important, they found that sentiment and confidence were remarkably correlated across countries.

External developments interact with the domestic economy in complex, uncertain, and even capricious ways. Central banks have to deepen their understanding of these interactions. Some of the channels through which cross-border transmission occurs are quite familiar—global prices, including commodity price movements; synchronization of business cycles; capital flows; strong comovement of asset prices; exchange rates of key international currencies; and interest rate policies of major central banks. Some of the transmission channels are less familiar. For example, the crisis has shown that even differences in regulatory regimes can trigger arbitrage-based action and dilute the efficiency of domestic policies.

Take managing capital flows. Emerging market economies experienced a sudden stop in capital inflows during the crisis as well as capital outflows—the result of global deleveraging. Now the situation has reversed and many emerging market economies again have net inflows. Managing these flows, especially if they are volatile, will test the effectiveness of central bank policies in semi-open emerging market economies. A country whose central bank does not intervene in the foreign exchange market will incur the cost of currency appreciation unrelated to fundamentals. If central banks intervene to prevent appreciation, they will have to contend with additional liquidity and potential inflation pressures. If they sterilize (soak up) the resulting liquidity, they run the risk of driving up interest rates...