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.

It is likely that regulatory policy would need to be in a constant state of alert for risks emerging in the financial shadows, which could trip up regulators and the financial system. In other words, regulatory fine-tuning could become the rule, not the exception. In this world, macro-prudential policy to lean against the financial cycle could become more, not less, important over time. With more risk residing on non-bank balance sheets that are marked-to-market, it is possible that cycles in financial assets would be amplified, not dampened, relative to the old world. Their transmission to the wider economy may also be more potent and frequent. The demands on macro-prudential policy, to stabilise these financial fluctuations and hence the macro-economy, could thereby grow. In this world, central banks’ operational policies would be likely to remain expansive. Nonbank counterparties would grow in importance, not shrink. So too, potentially, would more exotic forms of collateral taken in central banks’ operations. Market-making, in a wider class of financial instruments, could become a more standard part of the central bank toolkit, to mitigate the effects of temporary market illiquidity droughts in the non-bank sector. In this world, central banks’ words and actions would be unlikely to diminish in importance. Their role in shaping the fortunes of financial markets and financial firms more likely would rise. Central banks’ every word would remain forensically scrutinised. And there would be an accompanying demand for ever-greater amounts of central bank transparency. Central banks would rarely be far from the front pages. Which path?