Is there a need for a revisit of the traditional central banking model? Francesco Papadia, Senior Fellow at Bruegel, raised this question during a SAFE Policy Lecture on 27 March in Frankfurt. The economist argued against radical changes but advocated a sequential approach.
Papadia reminded the audience of the traditional central bank model’s structure with price stability as most important goal and, as a result, inflation targeting as framework for monetary policy strategy. In Papadia´s view, financial stability was rather neglected in this model. Accordingly, the systemic risk connected with the controlling of the interest rate were not seen as important.
This changed with the recent recession. In Papadia’s view, the European Central Bank (ECB) was forced to unconventional monetary policy measures to secure financial stability on short notice. For example, the ECB eased interest rates beyond the zero lower bound. The economist said that, overall, these actions were successful in the monetary area, since the interest rate control has been regained and spreads were brought to order. As a consequence, the classic central banking model has come under pressure, Papadia said: The responsibility for financial stability has become more important again, the border between fiscal and monetary policy has been blurred and new risks of moral hazard have been engendered. In the long run, this could jeopardize financial stability by lowering bank profitability or weakening their role as intermediaries.
Papadia hesitated to predict whether there is a need to review the inflation targeting framework in general. The former ECB Director General for Market Operations was inclined to say no. In his speech he did not call for radical changes to institutional aspects of the central banking model but advocated a sequential approach to dilemma situations. He does not expect that a clear separation between fiscal and monetary policy will be re-established in the near future. Therefore, Papadia pled for special decision making rules and new reporting requirements for unconventional monetary policies which have an impact on central bank balance sheets.
Further, there should be no financial support to imprudent sovereigns without conditions. If imprudent sovereigns or financial institutions are supported, deductibles should be required to disincentivize moral hazard, Papadia said.