End of the “Great Moderation” This brave new world looked set to continue indefinitely during the early years of this century. Inflation was low and output stable, the so-called “great moderation”. The Holy Grail of growth without risk seemed to have been discovered. Yet moderation was sowing the seeds of its own destruction, dulling the risk senses of central banks, regulators and market participants. In this vacuum, financial risk-taking rose to Himalayan heights. The global financial crisis of 2008 brought that decisively to an end. The financial system and economy tumbled from their Himalayan peaks. Great moderation gave way to “great recession”, the sharpest and longest-lasting since the 1930s. Central banks quickly 2  BIS central bankers’ speeches  acknowledged their pre-crisis blind spot – ballooning debt among both banks and non-banks. And, not for the first time in their history, they reinvented themselves. On the monetary policy front, extraordinary times resulted in extraordinary monetary measures. Interest rates globally were lowered to levels previously never seen, accompanied in some major advanced countries by purchases of government securities – so-called quantitative easing (QE). In some countries, central banks in addition purchased private sector assets, such as mortgage-backed securities and corporate bonds – so-called “credit easing”. Others, including the Federal Reserve and Bank of England, issued forward guidance to help clarify their future policy intentions and thereby shape the yield curve. This was terra incognita for central banks.

The Federal Reserve’s discretionary monetary actions during the Great Depression were a salutary lesson. BIS central bankers’ speeches  1  But the breakdown of the Bretton Woods system in the 1970s brought a further sea-change. Tight international rules gave way to national discretion. With the accompanying rise of “monetarism”, these monetary frameworks were often based around targets for the money supply. In most cases, the role of central banks was still to act as operational agent. But the technical nature of these regimes gave central banks a say in their design. A second step had been taken. The “great inflation” of the 1970s, together with repeated failures to hit money supply targets, began to change that picture further during the 1980s. Monetary discretion was found to have come with costs. In particular, it had given birth to what economists subsequently called the “time-consistency problem”. This problem arose from the temptation to over-supply money or over-relax regulations today, often to finance wars or to win elections, at the expense of inflation tomorrow. This problem was thus endemic among elected officials. The birth of independence As arm’s-length technocrats, without the need to finance wars or win elections, central banks were seen as a bulwark against these time-consistency concerns. Thus was born central bank independence. If decision-making power over monetary policy were delegated to central banks, not as operational agents but as principals, the time-consistency problem could be curbed at source. With this argument, central bank independence spread rapidly and globally during the 1980s and 1990s.