Central banks have traditionally functioned as the guardians of macroeconomic and financial stability. In recent years, central banks were at the forefront of protecting their economies and financial systems from the onslaught of multiple global shocks. They were put to the ultimate test in this extraordinary period of global turbulence and uncertainties. They had to change gear to revive their economies, ravaged by the Covid-19 pandemic, to wage 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.

Established Paradigm at the Turn of the Century

By the end of the 20th century, the theory and practice of central banking had converged around certain core principles. The first of these was that price stability would be the primary responsibility of central banks. This principle had its origins in the Great Inflation of the 1970s. Subsequently, inflation targeting as a monetary policy framework gained prominence in the early 1990s, both in advanced and emerging market economies (EMEs).

The second core principle stemmed from the famous ‘rules versus discretion’ debate in macroeconomics during the 1970s and 1980s, which led to a consensus favouring rules or constrained discretion in policy making. This was followed by institutional reforms under which inflation targeting got embedded within rule-based policymaking with some flexibility.

The third core principle concerned central bank independence which was regarded as crucial for achieving price and economic stability. While the target was set by elected representatives, the central bank was free to use the instruments at its disposal to achieve the given target. Central bank independence went hand in hand with increased accountability and transparency in the monetary policy decision-making process.

Evolving Paradigm of the 21st Century

In the 21st century, the global economy has endured a financial crisis (GFC), a pandemic, a surge in inflation, and geopolitical conflicts with global ramifications. Not long ago, central banks were combating deflationary tendencies following the GFC by cutting policy rates to the zero lower bound and implementing extensive quantitative easing. After the onset of the war in Ukraine, they had to combat inflation by raising policy rates to historically high levels.

The first quarter of the 21st century has provided important lessons for central banks, bringing several changes to the established paradigm of the 20th century. First, there is now greater recognition of the interconnections between price stability and financial stability. A key lesson from recent experience is the need to avoid viewing price and financial stability in isolation. The linkage between the two operates in two ways. First, extended periods of low and stable inflation can lead to complacency in the regulation and supervision of the financial system, as seen during the Great Moderation era of the 1990s and early 2000s. Second, periods of high inflation addressed by strong monetary tightening can jeopardise financial stability if interest rate risks are not adequately factored in, as witnessed in March 2023 when some banks in advanced economies faced sudden stress. Measures promoting financial stability can complement or constrain monetary policy, depending on their application. Financial stability measures aimed at effective regulation and supervision of banks, non-banking financial companies (NBFCs), and markets can enhance monetary transmission and help achieve price stability. However, unchecked monetary expansion can threaten price stability.

Second, the 20th-century orthodoxy of central banking was centred around a single objective (price stability) and a single instrument (short-term interest rates). Today, central banks have a broader mandate of overall macroeconomic stability, which includes price stability, sustained growth and financial stability. Conflicts between these objectives can arise, as seen when tighter monetary policies raise concerns about banking stability, or when pursuing price stability results in significant growth sacrifices. Therefore, central banks must employ multiple instruments — monetary policy, macroprudential regulation, and microprudential supervision — to minimise trade-offs and achieve better outcomes.

To meet these objectives, central banks have expanded their toolboxes, incorporating unconventional policy instruments such as negative interest rates, term lending facilities, asset purchase programmes and forward guidance. Additionally, macroprudential measures help promote systemic stability.

Third, central bank communication has become a vital policy tool. In the past, central bankers believed communication should be "shrouded in mystery" and kept minimal and cryptic. Now, managing expectations through clear communication is a vital instrument in the monetary policy toolkit. Forward guidance or the absence of it on the future path of policy rates, both state and time-based, — has become a key feature to deal with expectations. Central banks have learnt to build trust and confidence through social media, speeches, press releases and public interactions. Effective communication and transparency have played a pivotal role in the success of inflation-targeting frameworks.

Fourth, recent experience has highlighted the importance of monetary-fiscal coordination for better economic outcomes. During the pandemic, central banks worked closely with governments to address the crisis. Later, as central banks fought inflation, governments implemented supply-side measures to ease inflationary pressures, reducing the output sacrifice needed to lower inflation.

Fifth, emerging market economies (EMEs) have shown greater resilience in recent years. Despite facing traditional drivers of crises, EMEs have learned of ensuring financial stability as the regulator and supervisor of banks, other financial sector entities, financial markets, and payment systems. This holistic approach allows it to appreciate the synergies and trade-offs involved in various objectives and act appropriately using multiple instruments at its disposal.

The Flexible Inflation Targeting (FIT) framework, which got embedded into law in 2016, established the primacy of price stability among the objectives of monetary policy, but not unconditionally. It defines the objective as maintaining price stability while keeping in mind the goal of growth. The FIT framework retains the essence of the earlier multiple indicator approach without any ambiguity regarding the hierarchy of objectives. It provides flexibility to support growth when necessary. Financial stability, which is a precondition for price stability and sustained growth, is thus implicitly embedded as part of the broader mandate of the RBI.

It is this approach that has enabled the Indian central bank to effectively address the multiple challenges of recent times, balancing the needs of price stability, growth support and financial stability.

New Challenges for 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 affect central banks' core mandates of price and financial stability by causing sudden price pressures, damage to infrastructure, loss of economic activity and stress on fiscal balances. These events can also impact the balance sheets of banks and other lenders. In recent years, regulatory policies have begun to play a growing role in addressing climate-related risks. However, more work is needed in this area, with central banks supplementing the efforts of governments and other authorities, who will be at the forefront of climate-related initiatives.

Second, continuing geopolitical disturbances and geoeconomic fragmentations will present daunting challenges to central banks. The experience of recent years suggests that the future will likely be marked by dynamic geopolitical shifts, frequent supply chain disruptions, and greater barriers to trade, technology and capital flows. These will be new sources of shocks, often not well captured by existing macroeconomic models. It is therefore important for central banks to remain vigilant and respond in a nimble, timely and calibrated manner to navigate such turbulence.

Third, technology has permeated every aspect of human life, bringing about transformational changes in the financial services sector. The traditional banking system has undergone unprecedented technological transformation over the past decade. During crises, such as 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 levels of financial inclusion in less than a decade that would have otherwise taken several decades. Such infrastructures offer great potential for the future.

Fourth, fintech innovations are opening up new possibilities. The challenge for central banks will be to steer digital innovation towards a more efficient, prudent and stable financial system, reaping the benefits of DFI while building on their track record as trusted guardians of price and financial stability. Central banks will also have to address issues related to the regulation and supervision of digital lenders, the observance of fair practices, data security and privacy, and third-party service providers.

Fifth, the advent of artificial intelligence and machine learning (AI/ML) tools in financial services presents both opportunities and challenges. While their application in central banking and financial services has tremendous scope, it also raises concerns around data privacy, algorithmic bias, discrimination, cybersecurity and ethical issues. Central banks and other financial service providers must enhance their capacity to deal with these challenges.

While climate change and geopolitics may act as supply shocks, fueling inflationary pressures and slowing global growth and trade, innovation and AI, if well-supervised and properly harnessed, can enhance productivity and reduce costs. The net effect will largely depend on central banks' capabilities in managing these transitions. This, in turn, will shape the financial landscape of the 21st century.

Conclusion

Every crisis brings new lessons and ideas. The frontier of knowledge in economics has advanced with each crisis in the past. For example, the Great Depression of the 1930s highlighted the importance of fiscal and demand management policies; the Great Inflation of the 1970s emphasised the need for credibility and consistency in policy frameworks; and the global financial crisis of 2008 underscored that financial stability cannot be separated from overall macroeconomic stability. The sequence of unprecedented shocks since the pandemic has reinforced the need for policymakers to be agile, proactive, innovative and prudent in their policy responses, without being constrained by orthodoxies or dogmas. Economic theory and policies have evolved over the years, shaped by experience and lessons learned from each crisis. This has been the ongoing story of central banks.

With several global crises occurring in quick succession in recent years, central banking theory and practice are undergoing both subtle and, at times, significant changes. At RBI, our focus has been on pursuing proactive and prudent policies to ensure that the Indian economy evolves along a sustainable growth path. I am pleased to say that our efforts have yielded positive outcomes. The Indian economy has rebounded strongly from the pandemic and now contributes more than 18% to global growth. Inflation is on a downward trajectory, the external sector remains resilient with strong buffers, and the health of the banking and corporate sectors is robust. Fiscal consolidation is also underway.

As preeminent macro-financial policy institutions, central banks must keep reinventing themselves to keep pace with changing times. They must anticipate future risks and take suitable preemptive measures to avert or mitigate potential threats. I am confident that 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.

(Das is the Governor of Reserve Bank of India. This article is based on the speech delivered by Das during the First Himalaya Shumsher Memorial Lecture, organised by Nepal Rastra Bank on September 24, 2024.)

(The opinion article was originally publihsed in the  October, 2024 issue  of the New Business Age Magazine.)