Challenges facing Central Banks in the 2020s

Research is a core part of our mission at the Qatar Centre for Global Banking and Finance. Our research agenda aims to contribute to the knowledge frontier in monetary economics, finance and banking by giving practical, decision-useful insights that can guide central banks in the challenges they face in today’s global economic environment.

1. Rethinking central bank mandates, policy frameworks and governance arrangements

The model of independent central banks pursuing flexible inflation targeting served the world well in the 1990s and early 2000s. The episodic bouts of inflation instability that scarred central banks in earlier decades were conquered, and central banks were lauded for having achieved a “great moderation”. The Global Financial Crisis punctured this optimism. But central banks rediscovered their financial stability roots and some emerged with greatly expanded powers, including macroprudential policy, supervision, and resolution tools.

Questions were being raised about the adequacy of this policy framework even before the Covid crisis struck (e.g. Buiter (2016). The combination of ageing populations, slowing productivity growth, and large debt hangovers from the crisis led to secular declines in the equilibrium interest rate. And with it, widespread concerns about central banks’ capacity to support the economy in the next recession. Many central banks, including the Fed and the ECB, embarked on reviews of their monetary policy frameworks in response – though these were extremely limited in scope, taking existing objectives of monetary policy as given.

As we re-open our economies from lockdown, attention will inevitably turn to rethinking the role of central banks in the post-Covid economy. This, we think, will be driven by two principal forces. First, with interest rates close to their lower bound and macroprudential policies having already been aggressively eased, it is likely that fiscal policy will need to take on a greater role in macroeconomic stabilisation. What will this imply for central bank objectives and tools? Can the introduction of Central Bank Digital Currency CBDC) facilitate fiscal transfers in the next downturn and even help set negative interest rates? Can CBDC deal with the problem of effective lower bound and provide smooth monetary policy transmission? What role do macroprudential policies have on the profitability and resilience of banks?

Second, there are profound questions about how ballooning Covid-induced public debt levels will be paid for. At the very least, the boundaries between government debt management and monetary and macroprudential policies have blurred. But might we also face the prospect of “fiscal dominance”, and with it, higher inflation and financial repression? What should this mean for central bank’s operating mandates and even their independence? And what can we learn from macroeconomic theory and historical analysis in this respect?

2. Understanding new and emerging threats to economic stability

The world is becoming riskier, and radical uncertainty (i.e. unquantifiable risk) is now a key characteristic of the environment we face. To navigate this environment, central banks must understand new and emerging threats and their implications for macroeconomic and financial stability, and design policies that are “robust”. Research can provide a better understanding of how agents form their expectations, how uncertainty affects decision-making, and how these beliefs affect economic dynamics.

Aims

The COVID pandemic has caused the largest disruption to the global economy since the Great Depression. It has also generated profound questions for research. Some are pressing:

• What are the best approaches to “nowcasting” its impact and forecasting its likely evolution? What is the optimal policy for easing lock-down, and should it vary by sector?
• Do we need new measures of inflation and other economic indicators to guide these choices?

Other questions will be pored over for some time:

• What will the reorganisation of supply chains mean for productivity and global welfare?
• Which policy responses in advanced and emerging economies have been most effective, and are there unintended consequences to this hastily implemented policy mix?

The other big foreseeable risk on the horizon is climate change. Its economic implications had become a salient issue for central banks before the pandemic struck, with both the Bank of England and Banque de France announcing ambitious new climate stress tests, and the ECB declaring it a “mission-critical” priority.

Research questions here include:

• Should governments and central banks be promoting a “green recovery” from the COVID crisis?
• What path of carbon taxes would deliver this, and how should that path reflect uncertainty about climate sensitivity of CO2 emissions?
• What would a global climate stress test – accounting for the interconnected nature of the risk across institutions and borders – reveal, particularly if countries transition at a different pace?
• More generally, what is the role of central banks in pursuing the transition to a carbon-neutral economy?

Alongside this, global energy markets have changed significantly over the last five years. Fluctuations in relative energy prices have important implications for balance sheets in energy-producing countries and economic activity globally. What is the outlook for this market over the next decade, and how should this inform the process of economic diversification in the Gulf Cooperation Council region?

Finally, this is also an era of rapid and disruptive structural change in the financial system. Banks’ traditional role in taking deposits and making loans is being challenged by two forces: disintermediation via capital markets and non-banks subject to less stringent prudential regulation; and the emergence of FinTech and BigTech firms unbundled services in payments, retail lending, risk management and data analytics.

Potential research questions here include:

• What will these developments mean for the future role of banks, and where are they likely to retain an “edge”?
• How should central bank regulation and supervision be adjusted with the arrival of these firms?
• What will the “tokenization” of real and financial assets mean for liquidity and financial stability?
• What balance in regulation should be struck between fostering innovation and avoiding risk?

3. Developing new techniques for understanding the conjuncture and forecasting

The world is becoming increasingly complex and central banks, as well as other policymaking institutions, face ever more diverse challenges from climate change to the current pandemic. Established economic theories become less able to provide answers and recommendations to some of these challenges. As a result, there is an increased reliance on data to understand the conjuncture, forecast the evolution of the economy and its major trends across different horizons and to formulate policy responses.

At the same time, the abundance of data, both in established formats a variety of new guises such as social media or geolocation data, provide new information for capturing economic and business sentiments. Signals become increasingly difficult to separate from noise. A wide variety of data analytic methods commonly bundled together as “machine learning” are being widely considered and adopted. This brings further challenges as these methods originate from diverse disciplines, often lack a solid statistical and theoretical underpinning and may not be suitable for economic and financial data that are characterised by structural change over time. There is pressing research need to understand how big data can aid central banks. We must harness and modify new methods in this endeavour and address the challenge of extensive structural change over time while avoiding pitfalls such as extracting spurious patterns.

The Centre is uniquely placed to take up this challenge. Its links to the Banking and Finance Group, where it resides within the Business School, and the Data Analytics for Finance and Macroeconomics (DAFM) research centre, provide expertise in both data analytics and machine learning technology as well as extensive exposure to central bank issues and practices.

Current topics that fall within this research theme include: developing methods of textual analysis for modelling and forecasting economic and financial data; analysing complex multidimensional panel datasets using linear and nonlinear machine learning methods in the presence of structural change; interpreting machine learning methods with applications to macroeconomics and asset pricing and using machine learning algorithms to analyse vast micro datasets with applications to consumer price and banking transactions data.

This final research theme becomes a critical lens that will run through and inform all the research work of the Centre by ensuring that data forms the bedrock of validation and that rigour is present in all the analyses the Centre produces.