Opinion: Structural shifts demand a new central banking mindset

While the primary objective of most central banks — maintaining price stability — remains unchanged, the post-pandemic economic landscape has evolved in ways that require policymakers to rethink how monetary policy is designed and implemented. The relatively stable economic environment of the past few decades has come to an end. We have now entered a period characterized by profound structural changes driven by geopolitical fragmentation, technological innovation, demographic shifts and climate change. Furthermore, supply shocks have become more frequent and more persistent since 2020.

These forces are reshaping inflation dynamics, impacting economy’s growth potential, and altering monetary policy transmission mechanisms. Consequently, central bankers will need to exhibit greater flexibility, adaptability, and forward-looking decision-making.

Examining the major paradigm shifts since the early 1980s helps illuminate the extent to which the current environment differs from that experienced over the prior four decades. During the Great Moderation era (1984-2007), inflation remained low and predictable, GDP growth exhibited less volatility while remaining solid (expansions were long and were interrupted only by a few mild recessions), globalization expanded trade, and central banks could rely on well-established economic relationships when setting interest rates. 

During this phase, leading central banks concluded that credible commitments to low and stable inflation, often through explicit or implicit inflation-targeting frameworks, had made the economy more stable. It was widely presumed that expectations of inflation had become well-anchored, making it easier to maintain price stability with relatively small policy adjustments. 

The 2007-08 global financial crisis challenged some of the underlying assumptions formed during the Great Moderation era. It became apparent that price stability did not necessarily guarantee financial stability as asset bubbles and financial vulnerabilities arose even in a low inflation environment.  

The 2009-2019 period can be viewed as a post-crisis extension of some features of the Great Moderation era. Inflation and growth exhibited low volatility. However, inflation often stayed below its 2 percent target level and GDP growth was underwhelming, raising fears that the U.S. economy was stuck in a secular stagnation trap. Interest rates were kept at exceptionally low levels for a substantial portion of the decade. With short-term policy rates stuck at historical lows, unconventional monetary policy measures such as quantitative easing and forward guidance became part of the toolkit of major central banks.

The pandemic shock and its aftermath substantially altered underlying economic trends and gave rise to a new geopolitical reality. Since the COVID-19 pandemic, the global economy has been repeatedly disrupted by major shocks, including supply chain disruptions, energy crises, geopolitical conflicts, and heightened trade tensions. Rather than viewing these events as isolated crises, some argue that they represent a lasting structural transformation of the global economy.  

Importantly, several favorable structural developments that helped keep a lid on inflation over much of the past four decades can no longer be relied upon and may in fact be going into reverse. Following the collapse of the Soviet Union and the undertaking of economic liberalization measures by China and India, hundreds of millions of workers were integrated into the global labor force. Alongside the information and communication technology revolution, these developments enabled outsourcing and offshoring and the establishment of global supply chains.  

The decline in the bargaining power of workers and the prioritization of efficient economies of scale in the production process by global multinationals kept a lid on the price of goods and was a key factor in sustaining the Great Moderation era.  

Charles Goodhart and Manoj Pradhan argue that the economic environment that made inflation low and stable for decades has fundamentally changed, and central banks will have a much harder time keeping inflation under control in the future. Aging population (which generates an inexorable need for greater healthcare spending), falling birth rates, anti-migrant policies, deglobalization, and shift towards supply chains that prioritize resiliency over efficiency are major structural changes highlighted by them.

Fiscal discipline and central bank independence were key characteristics of the Great Moderation era. Since then, the fiscal landscape has deteriorated across much of the advanced world. Soaring public debt levels and persistently large fiscal deficits have created tremendous pressure on central banks to accommodate government financing needs. Fiscal dominance of monetary policy is no longer a theoretical risk but a genuine threat facing Federal Reserve and other leading central banks.  

Central banks face two other major challenges. First, with inflation remaining persistently above target levels, there is increased likelihood that expectations become unanchored. This will boost price volatility and make it much harder to reduce inflation in the future without causing a recession. 

Second, as noted by Fabio Panetta, governor of Banca d’Italia, monetary transmission channels are themselves evolving. Structural changes can either strengthen or weaken the transmission of monetary policy, making its overall effects less predictable. AI and digital banking may enhance transmission by enabling faster price adjustments and quicker pass-through of policy rate changes to deposit rates.

In contrast, population aging may reduce the responsiveness of household spending to interest rates, while geopolitical fragmentation may make investment decisions less sensitive to financing costs as firms and governments prioritize long-term resilience. Central banks must therefore continuously reassess how their policy decisions influence the broader economy rather than relying solely on relationships observed in the past. 

As the economy undergoes structural change and shocks evolve, new Fed Chair Kevin Warsh is right to advocate for a reassessment of key aspects of the central bank’s policy toolkit and its communication framework.  

Vivekanand Jayakumar, Ph.D., is Associate Professor of Economics at University of Tampa.

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