Central Banking in the 21st Century: Changing Paradigm
First Himalaya Shumsher Memorial Lecture by
Shri Shaktikanta Das, Governor,
Reserve Bank of India
Nepal Rashtra Bank, Kathmandu, Nepal,
September 24, 2024
I am delighted to have been invited by the Nepal Rashtra 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 Rashtra Bank for initiating this lecture series
in honour of Shri Himalaya Shumsher Rana, the first governor of NRB from 1956 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 Rashtra Bank and the Reserve Bank of India also
share a close relationship based on mutual co-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.3
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
emerges when 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 footnote8.
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
8
When the COVID-19 pandemic struck, the Reserve Bank reduced the policy rate sizeably by 115 bps
in a span of two months (March-May 2020); however, we refrained from being ultra-accommodative by
not reducing the policy repo rate below our inflation target of 4 per cent. In tandem, financial conditions
were eased substantially through liquidity augmenting measures amounting to ₹17.2 lakh crore
(equivalent to 8.7 per cent of GDP of 2021-22). All these measures were nuanced, against good
collaterals, with banks as counterparties and preferably with sunset clauses, keeping in mind the price
and financial stability challenges that may arise in future. During 2021, surplus liquidity was gradually
migrated from the short end to the longer horizon, which lifted short-term rates from ultra-low levels,
thereby obviating financial stability challenges. The pandemic measures exemplified how the Reserve
Bank could effectively balance different objectives - maintaining price stability within the flexibility
provided by the FIT framework, while also addressing financial stability considerations simultaneously.
Even during the COVID-19 pandemic when we eased policy rates significantly and in the subsequent
inflation upsurge when policy was tightened sharply, we gave banks greater flexibility by adjusting the
proportion of securities they could hold under the held to maturity (HTM) category to avoid marked to
market (MTM) losses that triggered the banking crisis of March 2023. Besides, we adopted a prudent
approach and have taken several initiatives to revamp regulation and supervision of banks, NBFCs and
other financial entities by developing an integrated and harmonized architecture. As a result, our
banking system remains resilient and healthy, as reflected in sustained growth in bank credit backed
by improved asset quality, adequate capital and liquidity buffers and robust earnings growth. Thus,
through our financial stability measures that strengthened market functioning, we facilitated price
stability by ensuring smoother policy transmission.
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.