1. The Future of Central Banking By C.A.E. Goodhart Financial Markets Group London School of Economics Introduction There are three main aspects of stability of concern to a Central Bank (CB). These are:- 1. Domestic Price Stability 2. External Stability of the Value of the Currency 3. Overall systemic stability in the financial system. These are clearly not independent. Also with one main instrument, the short-term policy rate, the CB can only hit one target. Are there any subsidiary instruments that can be deployed? We shall consider these three functions of CBs in turn.

2. The Achievement of Domestic Price Stability A. A consensus model Unlike previous decades, a wide-spread consensus model of how the economy works; this is a sticky-price New Keynesian three equation model, consisting of an expenditure (IS) equation, a supply-side (Phillips curve) equation, and a CB reaction function to determine the short-term policy interest rate. 1. y t = b 0 +b 1 (R t - E t  p t+1 ) + E t y t+1 + v t b 1 < 0 2.  p t =  E t  p t+1 + α 1 (y t – y - t ) + u t α 1 > 0 3. R t = (1 -  3 )[r +  p t +  t (  p t -  *) +  2 (y t – y - t )] +  3 R t-1 + e t μ 1 > 0, μ 2 > 0 The symbols are as follows: y = log of output, y - = log of natural rate output, p = log of price level, R = policy determined short-term interest rate,  * = inflation target, v, u and e = stochastic shocks and E is the expectations operator.

3. Problems of consensus model:- 1. Supply side empirically troublesome; 2. Forward, or backwards, looking expectations; 3. Length of lags; 3.Transversality condition, and role of default and financial intermediaries. B. Central Bank objectives (i)Price stability, but an inflation target. (ii)Is there a trade-off between output growth and inflation in the long run (No) or in the short run (Yes)? Presentational problems. (iii) What about the monetary aggregates? (iv) What about asset prices? (v) How does housing fit into the CPI?

4. C. What could go wrong for Central Banks? The last 15 years have been very successful for most economies, inflation targetry and operationally independent CBs. But could there be a problem of ‘democratic legitimacy’, especially if interacting with slower growth? Problem for ESCB especially? Is there any analogy between judicial independence and CB operational independence?

5. External Stability A more difficult issue. No generally accepted model of determination of the exchange rate. Transmission mechanism used to be that raising interest rates appreciated the currency. Now, with more equity-based capital flows, not so sure. Also general decline in pass-through. Washington consensus:- a) focus on domestic price stability; b) remove exchange controls on international capital flows; c) float freely, except for small countries. Experience of 1997/1998 Asian crisis weakened support for this view, especially in countries borrowing in foreign currencies, and subject to ‘sudden stops’.

6. In Asia since 1998:- 1. effectively pegged exchange rates; 2. reluctance to relax outward exchange controls; 3. export-led expansion; 4. massive build-up of $ reserves. Results in imbalances, some slight inflationary pressures. Where now, following China’s policy change? A different perspective in major industrialised countries. Even so, concern about the fickle volatility of exchange rates. An advantage of the euro is that it stabilizes a participant’s effective real rate. Could intervention do the same?

7. Systemic Stability A. Managing the Reserve Base, the Payments System and the Money Market When initially founded, CBs have had strong government support. Hence becomes most powerful Bank in country. So other banks hold balances at CB as reserves, and seek borrowing rights. CB manages payments system and crises via Lender of Last Resort, and also becomes central repository of international reserves. Leads on to need to make interest rate effective, via open market operations. No serious challenge via e-money and IT.

8. B. Banking Supervision CB’s role gives it some information on commercial bank positions, but rivalry between CB and commercial banks. More concern with quality of the paper discounted (Real Bills doctrine) than with the health of bank seeking support. Patchy supervision prior to 1930s. Then from 1930 till 1970 financial repression. When liberal reforms in 1970s led to recurrence of financial crises, CBs stepped into vacuum, because only they could co-operate, via Basel Committee on Banking Supervision (BCBS), to write soft law.

9. But leading role of CBs short-lived: (i) Universal banks led to calls for a single unified financial regulator. This could be the CB, but arguments against this. Separation of FSA and CBs leads to problems of co-operation both within, and even more, between countries. Uncertain what will happen.

10. Conclusions A. Domestic Price Stability: A successful consensus. B. External Stability: Limited understanding and unhelpful volatility in practice. C. Systemic Financial Stability: Some functions firmly maintained and well-functioning; but problems of organising and co-ordinating responsibilities for financial supervision and crisis management remain.