Jan Smets: The future of central banking
Keynote address by Mr Jan Smets, Governor of the National Bank of Belgium, at the conference
"Ten years after the start of the crisis: contours of a new normal", organised by the Belgian
Financial Forum and SUERF, Brussels, 14 September 2018.
* * *
Ladies and gentlemen,
it is a great pleasure for me to address this conference organised by the Belgian Financial Forum
and SUERF on the impact of the crisis and how it may have shaped a new normal for the
economy, for the financial system and for central banks. I thank the organisers for having invited
me to share with you some of my thoughts on the future of central banking.
I will not surprise when I say that it is good to first look back before being able to fully understand
where we stand now, and, eventually, give insights on where we may go from here. Indeed, the
future finds its roots in the past, and the present is precisely what brings both together. So, my
plan is to first walk with you through time, starting on 14 September 2008 - the day on which
Lehman Brothers failed, now exactly ten years ago and which marked the start of the global
financial crisis. I will then say a few words on where we stand in the euro area at the current
juncture and seize the opportunity to briefly explain the monetary policy decisions the Governing
Council of the ECB took yesterday. Finally, I will devote the remainder of my talk to the
challenges for central banks going forward: what is the future of central banking and to what
extent will it be different from central banks' past?
As I said, exactly ten years ago we saw the start of the global financial crisis and some of its
repercussions are still felt today. Not that there had not been worrying signs before. On the
contrary, already back in August 2007 banks started to hoard liquidity and on 9 August 2007 the
ECB was the first central bank which had to inject liquidity in the money market. Be assured, I
am not going to give you every single detail of the actions we undertook since then. I just want to
stress that by then many observers were impressed by the sheer size of the liquidity injection -
namely €94 billion - which by now is really small compared to the almost €3.5 trillion increase in
the balance sheet of the Eurosystem we have seen in the meantime.
Indeed, the worst still had to come and in September 2008 it came abruptly in the form of a
fullblown worldwide banking crisis. Those were the days during which in Belgium alone two major
cross-border banks had to be rescued in two consecutive weekends. Very soon the real
economy was hit too: euro area output dropped by around 4.5% in just two quarters and similar
sharp contractions where seen elsewhere. We now refer to this as the "Great recession",
contrasting sharply with the "Great moderation" - the qualification many people had given to the
two preceding decades.
Just at the time that the real economy started to recover, the euro area was hit by a second
recession which came with the sovereign debt crisis. That showed how much imbalances had
been built up in the euro area and how ill prepared it was in weathering a severe economic
shock, both at the level of the individual member states and at the level of the - indeed -
incomplete monetary union. The consequences of the multiple feedback loops between weak
banks, weak sovereigns and weak economies were devastating and eventually threatened the
euro itself in 2012. That is when the whole EMU deepening agenda was born and since then
major progress towards completing the monetary union has been made, particularly in the field of
banking union. This process is still unfinished, an aspect which will be discussed in Poul
Thomsen's keynote address at the end of the conference. Still, I think that it was essential in
bringing about the recovery, together with the actions of the Eurosystem, namely the Outright
Monetary Transactions, the credit easing policies and, finally, the additional stimulus provided in
the form of the Asset Purchase Program and the forward guidance on policy rates.
Early 2015 the Governing Council of the ECB indeed decided to significantly step up its
accommodation. With a large amount of idle resources and with new headwinds stemming from
emerging market economies, inflation had dropped to very low levels and inflation expectations
started to show signs of downward drift. Not only was there a risk that the inflation outlook would
no longer be in line with our aim of inflation below, but close to, 2% over the medium term, there
were also increasing indications that the economy could slip into outright deflation.
Compared to that period, the economic situation in the euro area has improved a lot. The
recovery has strengthened and broadened. All euro area countries are now growing. Contrary to
the previous recovery phase, domestic demand is playing an important role, not in the least
because it has been underpinned by our monetary policy measures. Employment creation has
been particularly strong and drives households' consumption spending, while also investment
has finally recovered. The pace of economic expansion has recently decreased somewhat, on
account mainly of a less favourable external environment where the tendency towards more
protectionism and the problems in some emerging market economies dent trade, and
uncertainty weighs on confidence. These developments clearly imply downside risks. Still,
domestic demand remains robust and the slowdown of growth up to now mainly reflects a
normalisation after the particularly strong growth rates seen at the end of 2017.
With the absorption of economic slack, wage increases started to strengthen, and that process
will eventually result in feeding domestically generated inflation. While headline inflation has
recovered on the back of increases in the price of oil, core inflation will gradually benefit from the
process of domestic reflation, further supported by receding uncertainty in inflation expectations.
In view of these developments, the Governing Council decided yesterday that - very much in line
with the view already conveyed in June - progress towards a sustained adjustment in inflation
has been substantial so far and that it is confident that the convergence of inflation towards our
aim will continue in the period ahead, even after a gradual winding-down of our net asset
purchases. Therefore, we decided to reduce the monthly pace of our purchases to €15 billion
from October onwards and we anticipate ending them after December 2018, subject to incoming
data confirming our medium-term inflation outlook. While this is an important step towards policy
normalisation, we are also of the opinion significant monetary policy stimulus continues to be
needed to support the further build-up of domestic price pressures. Hence, we reiterated the
forward guidance on the reinvestment and on policy rates, implying that we do foresee a very
gradual process of policy normalisation. That will allow financing conditions to remain very
favourable and to support both the economy and the associated reflationary process we are
aiming for.
Having outlined where we stand, I should have paved the way for my reflection on the future of
central banking. How will it look like? What will be the focus of central banks in the coming years?
Well, at the risk of being a bit boring, I claim that central banks will continue doing what they did in
the past and that is, building trust and confidence in the money they issue. I see three main
dimensions here. As in the past, central banks will care about the value of money. In other words,
monetary policy will continue to focus on price stability and in doing so stabilise the purchasing
power of money. Central banks will also continue to take care of the safe nature of money,
explaining their strong interest in financial stability which has even increased since the crisis.
After all, the largest part of the money stock is not directly issued by central banks themselves in
the form of base money. On the contrary, it is created in the financial system and is held by the
money-holding sector as liabilities of financial intermediaries. A significant part of it is in fact
deposits with commercial banks. Without having sound financial institutions, money cannot be
truly safe, nor will it be fully trusted by the public. And indeed, during the worst days of the crisis
we have seen flight-to-safety flows into banknotes, and away from the deposits held with - by
then, mistrusted - banks. Finally, central banks will continue playing a key role in contributing to
the smooth functioning of the payments system and being active in overseeing this part of the
financial sector which is crucial to allow economic agents using the money they hold. With this, I
think, central banks will be very much in the business of making sure money performs well on
each of the three functions we typically attribute to it, namely being a unit of account, a store of
value and a medium of exchange.
At first sight, there is nothing new here, which confirms what I said earlier about the future finding
its roots in the past. Still, it is worth having a closer look at each of these central bank activities,
as I think they are subject to changes, be it as a direct consequence of the crisis or because
other trends have affected the economy, the financial system or the wider society.
Let me start with monetary policy and its focus on price stability. That focus served us well
during the crisis. By counterbalancing the disinflation, we avoided the Fisher type of debt deflation
effects and facilitated the necessary deleveraging process. It also helped us keeping control over
the real rate, at a time controlling it was complicated by the fact that we had to operate very close
to - if not at - the effective lower bound for nominal interest rates. This was not only helpful from
a macroeconomic perspective but was, I think, also favourable for financial stability. Of course,
our 'low for long' poses challenges for financial institutions and can lead to specific risks for
financial stability. Yet, I do think that some sort of leaning-against-the-wind counterfactual with
less monetary accommodation would eventually have been worse for financial stability, mainly
resulting from the negative macro feedback effects it would have caused. I am also of the opinion
that the associated financial stability risks should be addressed by appropriate prudential
policies, particularly macroprudential policies - a point to which I return later.
A continued focus on price stability, and on our specific definition of it, will also be very beneficial
going forward. By stabilising inflation and hence inflation expectations at a level below, but close
to, 2% in the medium term, we make sure that the steady state level of nominal interest rates will
be supported by an inflation compensation component of that magnitude. That in turn will be
beneficial for financial institutions as in many cases their business models have difficulties in
coping with very low nominal interest rates. This inflation buffer will also contribute to safeguard
monetary policy's room for manoeuvre during downturns. While all this is already underlying our
definition of price stability from the beginning, the arguments supporting this choice have even
gained relevance. Indeed, compared to that period the steady state real rate - often referred to as
the natural rate - has dropped and that is, I think, one of the important features of the new
normal.
This new normal will come with new instances of lower bound incidence. So, central banking of
the future should be prepared for such situations and be capable to deploy all tools which we
now have labelled unconventional monetary policy. Active use of the central bank balance sheet
and forward guidance will very likely become more standard instruments in our toolkit. That of
course implies that we should be operationally ready to use them. More importantly, it also
implies that we must manage these tools carefully during the normalisation phase, so as to fully
safeguard their effectiveness for the future. In that sense it is important that we stick to the
conditionality we have introduced in our forward guidance formulation. That does not only
facilitate reaching our aim today; it is also an investment in our capacity to use forward guidance
in the future.
Let me now move to the second domain which will be prominently part of central banking of the
future, namely financial stability. While we are still somehow in the process of dealing with the
consequences of the credit bubble, it became clear from the outset that just cleaning is no longer
an option going forward. Hence a bunch of policy initiatives has been undertaken to mitigate risks
and enhance the resilience of the financial system. New standards for regulation and prudential
supervision were introduced in the form of more demanding capital and liquidity requirements
and the resilience of financial institutions is now also assessed by means of stress-testing. On
top of that, with macroprudential policy, a new policy domain has been created. It is natural to
see central banks playing an important role here, given their knowledge of the financial system
and their macro reflex typically adopted in the monetary policy domain. That is a clear trend we
see worldwide since the crisis.
Obviously, being more active in the financial stability domain comes with new challenges and, to
some extent, also with new risks for central banks. Despite considerable progress made in the
macroprudential policy domain, additional research on its transmission mechanisms is still
needed. Such research must also address the issue of interactions with monetary policy. I
claimed earlier that monetary policy should keep its primary focus on price stability and that
prudential policies should act as the first line of defence against financial instability. That setting
indeed comes closest to Tinbergen's ideal world where two distinct policy instruments are
available for two different objectives. Still, it would be naive to think that monetary and
macroprudential policy are two fully independent instruments, as they both act through the
financial system. So, I think the future of central banking also lies in learning more about possible
interactions, complementarities and scope for effective coordination between monetary and
macroprudential policy, without blurring, though, the distinction between the different policy
domains, their respective mandates and accountability frameworks.
I would like to flag one more challenge in this domain, which will have an impact on the future of
central banking. Part of the argumentation of having prudential policy as the first actor in the
financial stability domain rests on its capability to be more targeted, while monetary policy is often
seen as too blunt an instrument for these purposes. However, this more targeted nature tends to
come with more pronounced distributional effects. Moreover, financial stability will always be a
shared responsibility where fiscal authorities have their role to play. For these reasons, tensions
could arise when these instruments are given to independent central banks. But at the same
time, there are also forces pushing towards allocating them to independent institutions. Doing so
indeed allows coping with the so-called inaction bias, which in this case may be quite
pronounced precisely as a result of the targeted, and therefore fairly visible, way these policies
work. I do not think we have already reached a new steady state on this, and institutional settings
may still evolve depending on further experiences gained in this field. By the way, they now differ
quite a bit across jurisdictions which is an indication that the search for the optimal set-up has
not yet come to an end.
Contributing to the smooth functioning of our payments systems is the third pillar on which future
central banking will rest. While often having been a less visible task, it is nonetheless crucial for
fostering trust in money. This dimension nowadays gets a lot of more attention than in the past,
in view of technological advances and progressing digitalisation. New financial players -
socalled Fintechs - often focus their activities on payments services. Evidently, the Fintech agenda
is a wider one which affects the entire financial system and which central banks, of course,
monitor closely from a financial stability perspective. Moreover, digitalisation and new ways of
producing and consuming will have a strong impact on the entire economy. They will drive many
macroeconomic variables and questions on the new way of functioning of the economy are
popping up, be it from the point of view of measurement or from a more conceptual perspective.
Hence, these developments will also shape a new environment for monetary policy. Still, it is in
the payments sphere that the technological advances have already had their strongest impact on
central bank activities. And that will not change anytime soon. The future of central banking
therefore will heavily depend on central banks' ability to keep up with innovation and digitalisation.
One specific phenomenon here, which has drawn a lot of attention lately, is the emergence of
so-called crypto currencies. If successful, these alternatives could threaten our monopoly of
issuing money and therefore also our ability to conduct monetary policy. Being moreover out of
the control of prudential supervision, success of these crypto currencies could also endanger
financial stability. That is why we monitor these developments closely. However, given their still
limited scope, I do not see pronounced risks at the current juncture. Moreover, the intrinsic
features of crypto currencies - their inherent volatility, particularly - implies they perform poorly
as far as the traditional functions of money are concerned, in turn explaining why their success is
limited. Still, we should not be complacent. Only to the extent that central banks will be
successful on all three fronts I have mentioned, they should not fear outside competition. And at
the same time, central banks should be open-minded with respect to the new technologies
underlying these developments, as they can potentially be of use for themselves.
Somewhat related to this, the idea has been floated that central banks could issue their own
digital currency. Let me be clear from the outset, a central bank digital currency is conceptually
fundamentally different from the so-called crypto currencies. It would just be another form to hold
the same money. While being electronic in nature, it would in terms of risk characteristics, for
instance, be very similar to the banknotes we issue. Here too, central banks should be open
minded and carefully weigh pros and cons of possibly going this way. On the pro side, different
motivations are put forward, ranging from offering an alternative for disappearing cash, to move
away from the system of fractional banking or circumventing the lower bound constraint. On the
con side, there are concerns regarding the structural changes it would imply for the banking
sector, the possibility of having pronounced digital bank runs and the risk of a structurally longer
central bank balance sheet and hence a more pronounced allocative role for central banks. Any
steps towards a CBDC should therefore be subject fo careful consideration, and further research
is warranted.
I have done the tour of the most important domains in which central banks will be active in the
future and I have highlighted to what extent they may differ from what was done in the past.
Before concluding, I would like to make three final observations of a general nature on the way
central banks will function.
First, with the degree of globalisation we have seen so far and the strong interlinkages between
economies in both the real and the financial spheres, I do think that the international dimension
will become still more prominent for the central banking of the future. While mandates continue to
be geared towards domestic objectives, one's actions can spill over to other economies, which
in turn can generate spillbacks for the own economy or financial system. As a minimum, this
calls for an enhanced exchange of information about what is going on in the respective
jurisdictions, if not for more active policy cooperation. The Bank of International Settlements in
Basel plays already an important role in this respect and this is likely to become more
pronounced in the future.
Second, we see worldwide that central banks have come under increased scrutiny since the
crisis. While initially their prompt reaction to the crisis was widely applauded, support for later
actions has weakened and some of them are openly challenged. Calls to restrain the discretion
of central banks are openly made. I see several reasons for this. First, a lot of the crisis
resolution de facto fell on the shoulders of central banks. That forced them to stretch the
interpretation of their mandates, the backlash of which is felt now. It also implied overburdening
the central bank and a suboptimal reaction to the crisis, giving rise to the impression that central
bank action was not effective. On top of that, many of the policy actions were new and not
always well understood. They generated a lot of concern, for instance regarding the risk
implications of the balance sheet policies and the distributional effects of the asset purchases,
claimed to be regressive in terms of income and wealth distribution - a claim wich however
abstracts from the strong macroeconomic effects the asset purchases had as these benefit, via
the job creation they entail, to the most vulnerable group in society, namely the unemployed.
Finally, the broadening of central banks' remit into the financial stability domain has also
contributed to it, while at the same time complicating somehow the accountability framework.
To counter these forces, central banks have to be excellent policy makers. For that a profound
knowledge of the economy and the financial system is needed. The future of central banks will
therefore very much rest on their ability to be adequate knowledge centres. At the same time,
transparency must be enhanced and appropriate accountability frameworks are needed.
Increased communication efforts will have to be made to explain policy actions, not only to the
more informed audience of financial markets participants but also to the wider public. The skill to
translate central bankers' knowledge into non-technical terms has to be developed.
Finally, just like every other enterprise, central banks must adapt their ways of working to the
standards imposed by the changing environment they operate in. Non-hierarchical,
multidisciplinary work processes should unlock the knowledge now sometimes contained in local
silos. Enhanced diversity of staff should both improve the quality of work and increase society's
association with the central bank and its policies.
I conclude. Price stability, financial stability and promoting the smooth functioning of the
payments system will also in the future govern most of central banks' actions.It is the task of
central banks, also in the future, to foster trust in money in each of these domains. This trust is
not something which falls from heaven; it has to be built, and maintained, on a daily basis. While
technical know-how of experts is of course essential, on its own it is not enough. The stability of
money is a common good and deserves a quasi-constitutional status. In other words, it is a deep
and precious fundamental which must be safeguarded under all circumstances, as a
prerequisite for welfare, but also for freedom and fairness. Therefore, it has to rest on strong
societal underpinnings and be shielded from the volatility or even arbitrariness resulting from
short-termism. Thus, it is fully justified to allocate this goal to institutions which have this stability
as their primary task and which are accountable for achieving it. That is precisely the mission of
central banks, also in the future.
I thank you for your attention and I wish you a pleasant stay at this conference.