WORKING PAPER SERIES

Central banks
in the 21st Century

Luiz Awazu Pereira da Silva(Tokyo College, The University of Tokyo)

June 6, 2024
TC-E-24-1

Tokyo College, The University of Tokyo

TC-E-21-1

This paper is compiled from the transcript of a public lecture titled “Central Banking in the 21st Century,”
delivered at Tokyo College on May 29, 2024.

Central banks in the 21st Century
by Luiz Awazu Pereira da Silva1
Tokyo, 29 May 2024
Let me thank you for the kind invitation to share my thoughts on Central Banking in the 21stCentury, in this public lecture at the prestigious Tokyo University. It is a privilege and honour
to speak to you. In my address I would like to think together about challenges for central
banks in the coming years and how they might address them.
Before going any further, why should anyone be interested in Central Banks? For sure, they
became recently like “rock stars” and well-known as our “ultimate defence” against
catastrophic recessions, the Global Financial Crisis, COVID-19, the Cavalry that comes when
all is lost, “the only game in town”. But more technically speaking because they are the agent
implementing monetary policy in our societies, a key component of what is called
macroeconomic stabilization policies aiming at ensuring low and stable inflation (pricestability) and reducing the likelihood of banking crises (financial stability). The othercomponent is fiscal policy under the responsibility of governments. In this second decade of
the 21st century, central banks, and central bankers face six major challenges and need toreflect carefully on how the new challenges could affect their role: (1) the re-emergence of
inflation, in the short and medium-long term; (2) dealing with financial exuberance; (3)climate change; (4) inequality; (5) digital financial innovation and artificial intelligence; and(6) independence, mandate and accountability.
Challenge 1: Rising inflation in the short and medium-long term
The first part of the challenge, in the short-term, relates to the re-emergence of inflation.
After the Great Moderation, the Global Financial Crisis (GFC) and Covid-19 prompted an
unprecedented series of measures of monetary and fiscal stimulus. During a decade-longpost GFC period, many advanced economies experienced a Japan-like puzzle with rather

1

Visiting Professor, University of Tokyo. Deputy General Manager of the Bank for International Settlements (2015-2023), Deputy
Governor of the Central Bank of Brazil (2010-2015), Deputy Finance Minister in charge of international affairs (2004-2006).

1

fears of deflation and the under-shooting of the inflation target2. But then inflation returned
mid-2021, starting to rise after the faster-than-expected post-pandemic recovery, as supply
chains were stretched. Price increases accelerated further after Russia invaded Ukraine, withfood and energy prices driving inflation higher. Many advanced economies experienced
headline inflation rates not seen in decades. And even if by now, May 2024, headline
inflation has fallen, core inflation is proving to be more resilient than expected. Withhindsight, and when core inflation is resilient, it is easier to be more “hawkish”.
In the middle of 2021, the debate started about how transitory was this inflation episode,and therefore the timing and intensity for policy reaction. Surprised by the 2021-22 surge ininflation, the central banks of advanced countries initially put more weight on aninterpretation of the inflation surge as essentially a series of “supply shocks” starting withenergy and food prices. But then other factors on the demand side materialized: thepresence of Covid-related savings that could validate price increases, the tightness in thelabour market especially in the service sector accommodated by higher wages3. All this madeinflation more difficult to forecast and repeated under-estimation mistakes entailed someloss of credibility. Despite no clear de-anchoring of inflation expectations, inflation was
indeed more resilient than expected. Therefore, central banks had to engage into a much
faster and aggressive tightening cycle. And despite that, the “last mile” of the convergence
path is proving to be more complex, with each monthly inflation data point creating debate
among central banks’ watchers and market participants. As we are still far from their 2%
inflation target, it seems difficult to declare victory for this tightening cycle. Therefore,
communication has evolved and been more cautious with a re-pricing of fewer cuts
underway: this “last mile” has become a challenging balancing act especially regarding thecommunication of the stance being adopted and the way forward.
Unlike their peers, facing these challenges, emerging market economies (EMEs) have
weathered the recent crisis much better than before. Traditionally, EMEs have experienced
greater vulnerability to monetary tightening in advanced economies. Risk aversion
associated with weaker institutions and macro-financial imbalances made them more
vulnerable to shocks, including spillovers from advanced economies. Therefore, in the past,
tightening in advanced economies has triggered sudden stops in capital inflows and large
capital outflows, resulting in higher FX volatility. This time, it was different. EME central
banks started to raise interest rates ahead of their peers in advanced economies, confirmingthat they have indeed strengthened their policy frameworks. Stronger macroeconomic2

Under the textbook manual of inflation targeting regime followed by most central banks, fighting inflation requires monetary policy
rates to be set at a level that ensures convergence to a defined and pre-announced target, anchoring of inflation expectations, in a
specified timeframe while inflicting minimal damage on activity, employment and financial stability. But the GFC, like the experienceof Japan, required central banks to maintain policy rates at very low levels, sometimes negative and make use of unconventional
policies such as massive purchases of assets to try to boost inflation up towards target.

3

Bernanke B. and O. Blanchard (2024)2

fundamentals and more robust corporate and government balance sheets, along with amore stable banking sector, have underpinned their traditional central bank response.
Thanks to these stronger fundamentals, the FX impact of advanced economy tightening wasmore muted than in the past.
So, in the short-term, it looks like the monetary policy stance will require high rates forlonger, accompanied by a more “hawkish” communication, perhaps diminishing the odds fora “soft-landing” in advanced economies.
But there is a second part of this inflation challenge, the medium-long-term, about the futureof inflation. There are new challenges already in sight, various “structural” changes thatmight affect inflation in the future. What are these? Essentially changes in factor markets
and the re-pricing of risks that could result in cost-push factors, whether one-offs or perhaps
extended over a longer period of time.
The fading of the disinflationary effect of integrating into the global economy a large
number of new workers from China-India-Russia-Eastern Europe; that contributed toreducing substantially global production costs of goods and services; global growthwith low wages and low production costs, which had contributed to the decades ofsuccess of the 2% inflation targeting regimes, is coming to an end, together major
new demographic trends4; on top of that the current rise in protectionism and higher
import tariffs will not help desinflation.
The reshaping of global trade due to geopolitical tensions including the war in
Europe; the “re-shoring” or “friend-shoring” of many productive activities, motivatedby geopolitical insecurity, wars and localized conflicts, is also creating higher costs ofoperating global value supply chains; one can add to that, changes in transport routes,
etc; all this increases global production costs.
The higher wages due to tightness in labour markets, reflected in higher post-Covid
reservation wages, accepted given unfilled vacancies; even without thestrengthening of traditional trade unionism, many wage demands have been met incertain service sectors; ironically, the widespread political resistance in many
advanced economies to greater immigration of unskilled labour will not contributeto disinflation either.
The costs for greening our economies, in terms of both technological investments
and higher production costs due to regulation and taxes on activities with a high4Goodhart and Pradhan (2020).

3

carbon footprint; the beginning of the transition to carbon neutrality or Net Zero5, ishopefully happening but it comes with the costs of using new renewable energy
technologies, which for now are still more expensive (although their costs are fallingand converging towards the ones of fossil-fuel based energy); this comes also withgreater regulatory pressure in the real economy (in Europe and the USA in relation
to standards for electric cars making them mandatory from 2030-35) but also for thefinancial system ( e.g. , more stringent disclosure standards for exposure to climate
risks, whether coming from Basel rules or IFRS standards).
So, this is the medium-term, but are these factors already starting to have an effect andshould central banks begin to incorporate this new narrative into their “guidance”? We will
come back to that.
Challenge 2: Financial irrational exuberance and instability
The success of the Great Moderation that stabilized in the 1990s and 2000s the price ofgoods and services was not accompanied by the end of financial crises. This is not new, weknow that the success of monetary policy regime such as inflation targeting in achieving low
and stable inflation was not able to do the same for many asset prices in financial markets,quite the contrary. We also know the inherent propensity in finance for “manias”, “bubbles”
and “panics” as portrayed by Charles Kindleberger6. Fernand Braudel taught us the role ofbankers and finance in putting in place “structures”, economic and social, such as organizedbehaviours, attitudes, and conventions, as well as physical structures and infrastructures.
That led to financial bubbles since the 17th century, after long-term financial cycles in Europe
with a periodic rotation of financial centres: from Venice in 14-15th century to Antwerp andGenoa in the 16th century, then Amsterdam through 18th century and finally London (andEngland) in 19th century. And even in the past history of finance, with relatively rudimentaryfinancial products (just plain vanilla loans and bonds) financial crises occurred. This was all
the more common when the housing market was the underlying asset that allowed wealtheffects to translate into large macroeconomic and financial vulnerabilities. Financial cycles
of booms and busts are well-known, despite regulatory improvements, they seem also to berelated to fading memories of past crises and herd behavior.
Indeed, Carmen Reinhart and Ken Rogoff 7 show that throughout history, developed anddeveloping countries alike have experienced a wide range of financial crises. Each time,poli□cians backed by “experts” have claimed that, "this □me is diﬀerent"―arguing that the5"Net Zero" refers to implementing environmental policies that ensure a balance between the amount of greenhouse gases (GHGs)
emitted into the atmosphere and the amount removed from it. It comprises various initiatives and efforts to mitigate climate change,
as reducing and offsetting emissions is critical to limiting global temperature rise. More on that below.

6

Kindleberger (1978)

7

Reinhart and Rogoff (2009)4

old rules of valuation no longer apply and that the new situation was different from thosethat led to past disasters like government defaults, banking panics, and inflationary spikes,
until the subprime debacle. Indeed, the late 20th century brought a dramatic illustration thatprice stability is not a guarantee for financial stability with the Global Financial Crisis, as
described by Alan Blinder 8 . And now the 21st century will possibly exacerbate further
financial "irrational exuberance" that is still a perennial challenge that all central banks haveto deal with, a term coined by Alan Greenspan referring to the unsustainable and overly
optimistic expectations that drive asset prices to levels that are not supported byfundamentals. The phrase has since become synonymous with speculative bubbles infinancial markets in Robert Shiller's words 9 . "Irrational exuberance" is likely to be now
exacerbated by new financial technology, decentralized finance (DeFi), the widespread
usage of algorithms for financial decisions, crypto-assets and Artificial Intelligence (AI), as weshall see next.
Challenge 3: Climate change
The third challenge is presented by climate change and it is now increasingly present in ourdaily lives. Climate change impacts central banks’ core mandates because it affects bothprice and financial stability. Indeed, climate change represents a new type of systemic risk,
which we have labelled a Green Swan.10 Unlike rare tail events, such as the Black Swans of
the Global Financial Crisis, Green Swans are doomed to happen with certainty if notaddressed by appropriate policies.
Climate change presents two main kinds of risk. Physical risks stem directly from the effects
of more frequent extreme weather such as more frequent floods, heatwaves, rising sea
levels or lower crop yields. Transition risks stem from the transition to a net zero economy,
which can produce changes in asset valuation due to new consumer preferences, newregulation related to exposure to climate-related risks and the consequent migration to newtechnologies.
As there is no “silver bullet” to address these risks, central banks need to coordinate theiractions with other stakeholders such as governments, other public agencies, the private
sector and other actors in society, locally and globally.
Coordination is all the more relevant because climate change is a global negative externalitythat forces our societies as a whole to confront complex challenges. On the one hand,climate risks threaten macroeconomic stabilisation. On the other hand, the financing

8

Blinder (2013)9

Shiller (2000)

10

Bolton et al (2020).

5requirements of investing in the innovations needed to foster a net zero economy call forthe mobilisation of very large public and private financial resources.
Moving towards a net zero economy is a typically Schumpeterian creative-destruction
process that has large macroeconomic implications. Our best scientific experts estimate thatlarge investments in green technologies must be made quickly, with corresponding financing
needs. The financing mix is likely to involve several sources: taxes (including on carbon), andgovernment and private debt. While the economic impact will depend on the transition
speed and the precise financing mix, it is likely that climate-related investments will affectmacro-financial conditions in a substantial way. As alluded to above, these large investments
may increase the neutral rate in the economy, and they might also require novel forms ofprivate-public burden-sharing. Last but not least, climate risk-related financial regulationand supervision will be necessary to enable the financial system to adequately map its
climate risk exposures as well as channel these large investments effectively – along withmore stringent regulation in the real economy to ensure the path to net zero in our
production and consumption processes.
In responding to climate change, central banks have already joined forces in the Network forGreening the Financial System (NGFS). Their analysis is reflected in a number of important
published reports: the construction of climate scenarios to help financial sectors to workfrom a common set of hypotheses; guidelines for identifying climate risks; discussions on theimplications of climate change for monetary policy; solutions for financing the transition
with blended finance etc.
Climate-related action poses obvious challenges for central banks, some strictly related totheir traditional price and financial stability mandates and some when the radical
uncertainty that Green Swans bring is considered, such as the cost-push factors related tothe effects of global warming on agriculture, migration and labour, and the financing of thetransition to net zero. Finally, climate change has distributional consequences: it affects
primarily poor countries and poor people in rich countries. It is likely that we will have todeal with the severe distributional consequences of global warming, especially if we do not
manage to address it in time. That sense of urgency and the impact on the poor need always
to be remembered in order to strengthen and calibrate our policy responses. That brings us
to the next challenge.
Challenge 4: Inequality
Inequality within countries represents the fourth challenge. Inequality has declined between
countries as the world has become more integrated economically with “globalization” andthe spreading of technological progress. In the immediate post-World War II period, there
was a domestic effort to reduce inequality with the deployment of more effective social
policies in both advanced economies and EMEs, following Keynes and Beveridge ideas that
led to social welfare institutions. The distance between poor and rich countries has shrunk
6tremendously. However, later in the 1980s, inequality has increased within countries, in partdue to job losses due to the relocation of manufacturing to developing countries,
technological progress and the reduction of compensatory transfer policies: that led to somesocio-political fragmentation with “winners” and “losers” in many developed countries. Thisrising within-country inequality has compounded many other questions about fairness,
equity and socio-political stability. But, perhaps surprisingly, it also matters for monetary
policy.11
Research conducted at the Bank for International Settlements (BIS) shows that monetary
policy is less effective in more unequal societies. In very simple terms, as rich households
tend to save more and their consumption is less sensitive to their income, more unequal
societies may respond less to monetary policy stimulus. Furthermore, an adverse feedback
loop can arise, because recessions tend to increase inequality. More unequal societies
respond less to expansionary monetary policy and experience slower recoveries fromrecessions. This, in turn, keeps them more unequal. We call this “inequality hysteresis”.
Central banks need to understand the impact of inequality on monetary policy effectiveness.
In particular, this might imply exploring new types of modelling approach in fulfilling theirmandates, featuring heterogeneous agents, which some central banks such as the Fed andthe ECB have started doing. In addition, they can take into account the way in which fiscal
policies are addressing today’s income inequalities, through the progressiveness of taxationand the quality of spending on public goods such as education and health, while structuralreforms and policies can help to reduce future inequality, including through fostering
innovative financial technology for social inclusion. That brings me to the next challenge.
Challenge 5: Digital financial innovation, algos and Artificial intelligence
Digital financial innovation represents the fifth challenge. Technological innovations such as
big data, fast payment systems and distributed ledger technology (DLT) are gaining ground– in both the financial sector and the real economy. This is visible in digital payments, inonline lending and insurance, and in applications of DLT in crypto and decentralised finance(DeFi).
These technologies are helping to increase access to finance and are playing a key role infostering financial inclusion in many countries. The technological advances in digital financecan dramatically reduce the cost of processing information and expand the set of available
contracts – including in (social) insurance. This could, in principle, help to smoothconsumption and enhance welfare, allowing more people to escape poverty traps.

11

Pereira da Silva et al (2022).

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Digital financial innovation thus offers the potential for a brighter future. If we develop
common interoperable platforms and safeguard data privacy, we can strengthen global links
and improve resource allocation. Furthermore, we can offer financial tools for the previously
underserviced and poorer segments of our societies. We can also strengthen trust in thefinancial system through new, more widely available and higher-quality financial products.
In this way, digital innovation can contribute to a more efficient and more stable global
financial system.
Yet, there is a flipside to this. Technologies can also allow concentration and market power
and trigger new types of discrimination. To assess their net impact, one must look at all
aspects of the existing technological transformation and be guided by more data andevidence. What matters is how digital technologies are applied, and in particular what role
public policy will play.
Grasping this potential requires the public and private sectors to work together. The
development of digital financial products, like all technological advances, is a double-edged
sword. Used responsibly, new technologies can offer increased welfare for all, but they canalso result in new forms of discrimination.12 That is because digital innovation can also drivea fragmentation of the financial world. Differing systems can divide different user groups
and countries from each other. Globally, in the context of increased geopolitical tensions,digital innovation can foster segmentation and disintegration along geopolitical fault lines.
Locally, if abused, digital technologies can give rise to more sophisticated, and thereby lessperceived, discrimination against specific minority groups. They can also pose newchallenges to global and local financial stability by amplifying asset price volatility, contagion,
exuberance and, for example, accelerating deposit runs simply using smartphone aps. At theextreme, these trends could result in a more volatile financial system, eroding people’s trustin money.
Thus, central bank actions matter in digital innovation: they can steer digital innovation
towards a more efficient and more stable financial system, with new instruments forsupervision and more data points. Central banks can innovate and consider implementing
faster payments systems with new digital tools, such as central bank digital currencies. At
the same time, they can build on their track record as trusted safekeepers of price andfinancial stability. Conferring the credibility of a central bank on new digital tools offers a
new form of public good. However, the exponential development of crypto-assets without
a proper regulatory framework is just one among many signals of potential dramatic changes
where a multiplicity of hitherto human decision-making processes can be automated. If thisoccurs on a large scale, too many processes will escape from our human institutional settings,
which provide necessary checks and balances that have so far ensured that our ethical values

12

Pereira da Silva and Frost (2023).

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always play a critical role when deciding on how, when and to whom new technologies
spread. Yuval Harari has warned us against losing these safeguards13.
If at some point in the future, algorithms were to determine most if not all of our societies’
decisions, this will certainly go beyond mechanically applying some form of a Taylor rule tomonetary policy decisions. The recent leapfrogs in Artificial intelligence (AI) promises jumps
in productivity, greatly expanding the set of routine tasks that can be automated.
Productivity jumps seem particularly relevant for key public goods such as health care andeducation. Over the past decades, healthcare and education costs have increased relative tothe price of physical goods, because increasing demand for these public goods were notmatched by a commensurate increase in productivity. AI promises exactly such an increasein health care and education productivity: just imagine AI nurses analysing symptoms moreaccurately than human doctors can. Or imagine AI teaching assistants promptly answering
questions and explaining concepts better than professors can. Thus, AI could radicallychange the nature of health care and education, thus perhaps lowering costs and further
democratising access. But there is a but…
Indeed, progress in AI technology also has potentially challenging aspects. Given big data
and the scalability of computer power, there is a realistic chance for non-linear
developments, that is, large jumps in AI capabilities. AI with untrammelled capabilities could
play an unknown role if not properly supervised. Tireless AI surveillance could monitor
human activities, controlling and reducing the critical thinking by humans that is the basis
for innovation and epistemological revolutions. Even in a more benevolent scenario, we
might lose our control over an expanding set of economic, social and political decisionmaking. In addition, AI might replace millions of semi-skilled and even skilled jobs, at a pacethat is not commensurate with the creation of new activities for humans. Thus, the risk ofrising skilled unemployment in many sectors is not negligible, putting our social welfare
systems under further strain. This concern for AI’s distributional consequences for
employment is expressed by Daron Acemoglu and Simon Johnson.14
In addition, AI development might represent a new, non-biological form of intelligence,
raising ethical and practical questions about a potential new life form. We understandhumans to have human rights but how should we treat AI fairly?
Thus, AI poses unprecedented challenges for all of us. For central banks, one can see
increased powers to monitor price and financial stability with the help of AI. At the sametime, there is a possibility that AI might take over key decisions on price and financial stability
and challenge what has been so far the “art” of central banking: a reliance on many models

13

Harari (2018).

14

Acemoglu and Johnson (2023).

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to analyse data, project scenarios and make forecasts, but always in the context of adecision-making process where the balancing act of assessing the balance of risks was
conducted by humans, in a fairly sophisticated collegial way, with a well-tested institutional
setup, and under the scrutiny of society and its representatives15.
Conclusion:
To conclude, where do central banks stand and what to make of these challenges? As you
may remember Yogi Berra’s quotation, “It’s tough to make predictions, especially about the
future.”Central banks in this early 21st century are facing major challenges: (1) the harder “last mile”
for convergence of inflation to target but also the medium-long-term uncertainties for pricestability; (2) financial irrational exuberance again compounded by new crypto-assets; (3)climate change; (4) inequality; (5) digital innovation and artificial intelligence. In other words,
and in the next decades of the 21st century, most likely, central banks will face new
inflationary pressures from “greening the economy” and demands for higher wages, newforms of financial bubbles coming from the digital revolution, political pressure to be again“the only game in town”, perhaps provide “helicopter money” to patch socio-politicaltensions in societies and the unpleasant arithmetic of high levels of debt accumulated during
recent crises. The “future” is already with us in many aspects: the challenges that central
banks will most likely have to face, in a nutshell, all affect the current parameters that guidemonetary policymaking or the “stars” usually associated with the operational concept of aneutral level for the interest rate and also unemployment. A quick review of these:
We are perhaps at the beginning of a period of rising risk premia. The fiscal responses
to the GFC and Covid-19 has left us with high debt levels. For almost all countries(Japan is the exception) there are now significantly higher rollover costs of debt after
the recent increases in interest rates. The golden opportunity moment where real
GDP growth rates were above real interest rates on debt has passed. In addition,
advanced countries are having to face well-known demographic challenges,
struggling to maintain the quality of their social spending but worse, somehow
compelled to increase military spending and at the same time making efforts towards
decarbonizing their economies.
We are also perhaps at the beginning of a period of a rising “neutral rate” or r* formonetary policy. We might have reached the end of a “savings glut” and we arewitnessing a pressure from growing demand for more investments, including for thetransition to Net Zero. There is also increased productivity with new IT technologies

15

Blinder (1998)

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and the use of Artificial Intelligence (AI) that are radically changing the production
and consumption processes of various types of goods and services. Increased
productivity improves investment prospects, profitability and tends to increase r*. It
could be a way out of secular stagnation.
We are also perhaps at the beginning of a period of new financial excesses(cryptocurrency bubbles, less regulated non-bank financial activities etc.). Many new
financial markets risks are not covered by the current regulatory framework of BaselIII. Their spreading is exacerbated by the growth of the non-bank financing channel,
fintechs, Bigtechs, new fast payment technologies. Those new features have alreadymaterialized in the volatility of the value of crypto-assets, the rise of new non-bank,less regulated, financial institutions and liquidity/solvency crises (of the type of the
Sillicon Valley Bank run).
Finally, we are perhaps at the beginning of a period of new equilibria in labour
markets. New working arrangements might change preferences between
employment and leisure but technology can also bring a destructive effect on jobs(including semi-skilled and qualified white-collar ones). Some sectors will witness
wage gains but not all and there could be a possible need to increase safety nets,
transitional social transfers, etc. even in the difficult fiscal position and debt levels(described above). These are complex changes at play with impacts on our social andpolitical institutional set-ups and the way we see the “non-accelerating inflation
natural rate of unemployment”.
The answers and the policy responses by central banks to these challenges will have to breakfree from the various situations where their action became “dominated” by constraints
outside their reach16, fiscal, financial or even “political economy” dominance. In other words,
with rising inflation risks, rising r*, higher debt, higher investment needs for Net Zero,pressure for higher wages, higher social demands for a new Social Welfare State, central
banks need to clearly invoke Tinbergen’s separation principle and define their
responsibilities and those of other agents in the macroeconomy.

16

The obvious one is fiscal dominance, when fiscal policy dominates or influences the actions of its central bank, when high levels of
public debt and/or significant budget deficits and political forces pressures central bank to finance deficits or keep interest rates
artificially low to reduce the cost of borrowing and roll over debt more easily. It usually ends with higher risk premia and higher
inflation. The second is financial dominance where the priorities and stability of the financial sector significantly influence the actionsof policymakers, including central banks and governments. This might result from regulatory capture or excessive economic
dependence on the financial sector. The pressure in this case comes from private forces for keeping interest rates low for longer
than necessary to avoid valuation losses, limit financial costs and roll over debt more easily. And the third that could be labelled“political dominance” where the political economy around fiscal policy prevents its timely deployment during crises and/or isdelayed by political factors, putting central banks under pressure to be “the only game in town” and deliver quasi-fiscal policy
stimulus for example in the form of unprecedented expansionary balance sheet policies without necessarily the capacity to targetingthat fiscal authorities possess.

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For central banks and monetary policy, they operate inflation targeting regimes. They need
to focus precisely on how they will make the regime perform well (better than during theGreat Moderation?) in this new environment.
Inflation target. At some point in the transition to Net Zero, central banks will haveto carefully analyse their forecasts of inflation and then possibly consider theirtemporary but new inflation target, higher than the current 2%. Under the current
inflation targeting regime in monetary policy, this will correspond to the recognitionof an impact of a succession of supply and demand shocks for a period of time (theopposite phenomena of the disinflationary role played by China during the Great
Moderation). When and for how long is difficult to say but in any event, coordination
and agreement is crucial between all major G7 central banks. The adoption of acommon temporary new inflation target, needs to start in an agreed upon specificyear (naturally after stabilizing the current inflation surge) and the new x% target
should be discussed, calibrated and announced simultaneously by all G7 central
banks17. Regarding the rising neutral rate r*, the communication of the monetary
policy target and stance will also need coordination: if this is done adequately, for awell-defined period of time, it will help to anchor inflation expectations, strengthen
credibility, stabilize financial markets volatility and avoid excessive contractionary
policy. At the same time, with a higher neutral rate and a higher target rate, thenominal policy rate will have to be higher. But hopefully, the transition period, if
accompanied by appropriate monetary and fiscal policies, can bring a stabilizationand then a disinflationary trend with an increase in potential output, higher
productivity, cost reductions, etc. In other words, the communication could besomething like: (a) we will converge towards the 2% target and win the battle of the“last mile”; and (b) only by then, “after the victory”, we will define the policy stanceentering these new global macro-financial challenges with new cost-push factors that
could alter the growth path, the natural rates of interest and unemployment, andperhaps a new pattern for inflation, at least for a while.
Macro-Financial Policy Framework. To ensure price stability and restrain digitalfinancial exuberance, central banks can move toward an enhanced version of
inflation targeting, an Integrated Inflation Targeting frameworks (IIT) that uses in acomplementary but decisive manner monetary policy and other macroprudential
tolls such as financial regulation, FX interventions and capital flows management(CFM). In particular, this is what many EME central banks have been doing, learning

17This higher inflation target for G7 central banks should not be seen to provide more room for maneuver for them when facing thezero lower bound; it is rather to reflect structural (albeit transitory) cost changes and setting the right expectations for monetary
policy reaction. It also reflects a choice between two risks: leaving the current target at 2% and facing credibility losses for erring
systematically above the target (after a long period coping with the opposite situation) or recognizing the effects of cost-push factors,
rising the target temporarily but facing the risks of de-anchoring inflation expectations at a higher level.

12their lessons from past crises as they were subject to the spillovers of policies fromtheir major peers in advanced economies.18
This type of framework had been used mostly by many EME central banks and inbank-dependent economies. But upon reflexion, shouldn’t this approach beconsidered explicitly also for more advanced open economies? Small for sure but
even larger advanced economies. It is possible that a combination of a tightermonetary policy stance with a tougher macro-prudential regulation (eg., on the
housing market) would have been capable of reducing the risks that led us to the
Global Financial Crisis in 2008. Is might be also the case today, when we see the risksof bubbles in the non-bank financial sector, in the various developments of DeFi,
crypto-assets, etc that more financial regulation, disclosure and adequate monetary
policy could reduce these new systemic risks.
Now and importantly, for governments, fiscal authorities and fiscal policy, they operate
discretionary regimes even if many have explicit or implicit sustainability rules and automaticstabilizers. Here and ironically, there is increasingly a convergence between the constraints
faced by EMEs and advanced economies. Both need to focus just on how they will operatefiscal policy, debt and taxation in this new environment. Both need to address higher debt
levels, higher investment needs for Net Zero, pressure for higher wages, higher social
demands for a new Social Welfare State. Given the high levels of debt, it is unlikely thatmacro policies going forward can sweep the issue of some fiscal consolidation under the rug(even Japan, with still a lower cost of debt service and significant assets, is concerned).
Sailing through this new uncertain future with high debt and higher service costs is not going
to be solved by keeping low interest rate for a long period of time. The temptation of fiscal
dominance will be quickly priced by markets, risk premia will rise, inflation expectations will
jump. The differentiation of advanced and EMEs as distinct asset classes is diminishing as
illustrated recently by the United Kingdom’s risks repricing by markets for inconsistentpolicies, an episode that had many similarities with what many EMEs have experienced inmany instances. In addition, most EMEs facing crises have faced periodic limitations to run
counter-cyclical fiscal policies due to market sensitivity via higher risk premia to debt levels
and exchange rate depreciation. Therefore, it is important to reflect (and whenever possible

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Agénor and Pereira da Silva (2019 and 2024). An IIT can be defined as a flexible IT regime in which the central bank’s mandate
includes explicitly a financial stability objective. It uses an augmented policy rate to react also to some equilibrium metric of financial
activity and limit exuberance and excessive credit. For that, central banks use, in a complementary way, their policy rate and macroprudential policies that need to be calibrated jointly because they both affect the cost of lending in the economy, to achieve
macroeconomic and financial stability. Moreover, central banks can use FX interventions to smooth volatility, address systemic risk
in financial system but never to set a level for the exchange rate, since a floating regime should remain the first line of defense andpolicy.

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implement) some form of a sovereign wealth fund and/or a fiscal stabilization fund in order
to increase the policy room for manoeuvre during crises19.
So indeed, many economic and socio-political issues mentioned above are not a central
banks’ business, they are mainly a political issue, to be addressed with fiscal policy. But
obviously, the outcomes affect central banks’ objectives, and have to be factored in the way
they will operate monetary policy. The desirable policy-mix is one where there is a rationalburden sharing between stabilization policies and there is in addition the possibility toundertake public policies that favour sustainable and shared growth. It is unfortunate (butunavoidable) that policy-makers are confronted with the need for provide public support for
the transition to Net Zero (ie., fiscal spending on R&D, green investment, etc) and at thesame time set credible limits to more debt and more taxes. It is even more unfortunate (butalso unavoidable) that this is happening in a context of socio-political polarization in many
countries (and in the World) that makes more difficult to reach consensus on global policies,
on multilateral cooperation, on possible trade-offs or different sequencing of measures that
could ensure aiming at these objectives with a consistent set of policy instruments, globallyand locally.
At least at a country level, most likely, given the now limited space for new massive debt
accumulation, fiscal policy solutions would have to try to achieve at the same time debt
sustainability, financing (some of) the green transition (obviously with a much more massive
participation from the private sector) and creating more fairness in income distribution.
Accordingly, this could logically imply choosing a combination of more progressive taxation(eg., of wealth and high income) and innovative green finance, a selective set of new debt
instruments, for example “green bonds”. The political economy aspect of this new fiscal
policy is important to address the problems of rising inequality mentioned above. Taxation
will need to be more progressive and redistributive to produce more social consensus in its
implementation and thus prevent “political volatility”. And a positive collateral effect is thatsuch a progressive fiscal policy with stronger automatic stabilizers can remove some of theburden that has been put on monetary policy in the past and engineer a more effective
policy-mix.
Separating monetary and fiscal policies while improving their effectiveness as a mix is an old
idea and practice that is more necessary today after boundaries became blurred. Given thechallenges listed above the best course here is indeed to ensure clarity in the division oftasks between fiscal and monetary policy but also to make both work to address thesechallenges. It still brings inevitably questions about the institutional set-up in which central

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Most EMEs have increased significantly their levels of international reserves in that same spirit of self-insurance and building
counter-cyclical capacity for periods of market stress. This has allowed them to smooth excessive volatility of their exchange rates
via FX interventions while keeping a floating (but managed) exchange rate regime, under their IT monetary policy regime. De facto,
as stated above, it is an Integrated Inflation Targeting regime.

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banks have been successful in the 20th century: their independence but also theiraccountability to elected authorities and also society. The more central banks can keep theirtechnical expertise and neutrality while contributing to incorporate the new objectives ofsocieties, the more they will demonstrate that it is worth having unelected experts informing
the general public and giving sound policy directions on the two objectives of price andfinancial stability. Last but not least, to the extent that society provides new explicit
mandates for central banks, it would certainly facilitate clarity in the communication of theiractions. Given their capacity to have dual mandates (price and activity) and even to be
responsible for financial stability, it is also possible to have new hierarchical objectives where
central banks can look more explicitly into climate change, income heterogeneity and thevast arrays of consequences of the digital revolution.
Can this future policy-mix be successful? The combined effects of these challenges are yet
hard to grasp, precisely because the uncertain interaction between decisions taken acrossdifferent policy areas. The way forward is perhaps not to despair and to use the traditional
wisdom of Tinbergen’s separation principle. Central banks will have to make clear that theirfunction has limits: they are impacted by other policies but they should contribute in thecoordination process to address the challenges listed above. However, central banks alone
cannot respond to deep-rooted structural issues such as the “greening” our economies,
rising inequality, lower productivity, declining growth trends, etc. All these issues ultimately
require constructing policy frameworks that reflect the new demands for a balanced social
contract that encompasses macroeconomic stability, environmental sustainability andfairness and equality in our societies, with defined objectives and instruments, having theaim of best serving the common good20.
Thank you.

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Tirole (2017)15

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