Introduction to Central Banks
The concept of central banks has been a topic of discussion lately, with many people questioning their performance and priorities. Recently, the Federal Reserve faced criticism for spending money on renovating its premises while reporting significant losses. This criticism raises questions about the true performance of central banks and what metrics should be used to evaluate their success.
Central Banks and Society
Central banks play a crucial role in the economy, and their actions have a significant impact on society. The link between central banks and society is more important than the relationship between the central bank and the government. Central banks should strive to contribute to social capital by offering predictability, confidence, and credibility while pursuing policies that create socially optimal outcomes. It’s all about putting purpose above their performance numbers.
The Role of Central Banks
Unlike commercial banks, a central bank’s profits or losses largely represent transfers within the financial system, not the creation or erosion of wealth. The bottom line reflects transfers across sectors, depending on interventions in foreign exchange, interest rates, or liquidity management. Central banks do not consider their annual financial performance as a key output metric, unlike commercial banks. However, profits are essential to maintain a resilient balance sheet and financial independence from the government.
Performance Measurement
If a central bank achieves low and stable inflation, its balance sheet will have little volatility, and the balance sheet should grow as demand for central bank liabilities increases with the volume and value of transactions in the economy. However, when pursuing exchange rate targets, central banks may build large foreign asset holdings either to prevent devaluation or offset appreciation. The increase in foreign assets can create more central bank money than is naturally needed.
Key Performance Indicators
Central banks should adopt mark-to-market accounting (recording assets at today’s market value) consistent with International Financial Reporting Standards (IFRS) to reflect their true financial conditions. More importantly, they must differentiate income recognition (earnings) from income distribution (spending). Unrealized gains (e.g., when bonds or reserves rise in market value without being sold) should not automatically flow to fiscal authorities. Instead, they should be used to build capital buffers in good times, bolstering resilience during stress periods.
Best Observed Practices
Several jurisdictions, including Australia and the UK, already follow asymmetric rules, where unrealized gains are used to build capital buffers. Furthermore, before distributing profits, central banks should use stress tests to assess whether projected income and capital buffers are sufficient under adverse scenarios. Income distribution rules should be both forward-looking and risk-based to account for the potential losses from unconventional monetary policies while safeguarding financial autonomy and, ultimately, their independence.
Conclusion
In conclusion, the profits or losses of central banks are not a suitable metric for evaluating their performance. What matters is how central banks deliver on their mandates. Central banks should prioritize stability, credibility, and independence over profits or losses. By adopting best practices and using appropriate performance metrics, central banks can ensure they are working towards the betterment of society and the economy. The true performance of central banks lies in their ability to maintain low and stable inflation, foster economic growth, and provide financial stability, not in their profits or losses.
