Central bank monetary control erodes as fiscal pressures mount
Post-crisis monetary frameworks are here to stay, weakening policy transmission, complicating inflation control and blurring institutional mandates.
In a nutshell
- Quantitative easing boosted reserves, reduced monetary precision
- Abundant reserves blur monetary and fiscal boundaries
- Structural fiscal deficits constrain central banking
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Enormous government deficits have changed the fiscal landscape. But the deeper problem is what central banks have done to their own toolkit − the traditional and non-traditional monetary and regulatory instruments used to manage the money supply, control inflation and ensure financial stability.
In the United States, the Federal Reserve raised its key Fed Funds interest rate 11 times between March 2022 and July 2023 to a high of 5.5 percent. Inflation, which had peaked above 9 percent, eventually came down. The tools worked. Or so the story goes.
A closer look shows a more complicated scenario. Following the financial crisis in 2008, the Fed’s balance sheet, which ballooned to nearly $9 trillion during successive rounds of quantitative easing − when, if interest rates are already near zero, central banks create new money to purchase assets and generate additional liquidity − never meaningfully normalized. The European Central Bank (ECB), constrained by the diverging fiscal paths of 21 sovereign members, had to invent new instruments mid-cycle just to keep its rate hikes from blowing up Italian bond markets. On top of these monetary challenges, government deficits throughout the Western world remain structurally elevated, not as a crisis response, but as a permanent feature of the fiscal and political landscape.
The debate is not whether central banks can move their policy rate − they clearly can. The real question is whether that rate or any other tool in the monetary toolkit still translates into reliable, precise control over the money supply. The answer is more complicated than the post-2022 inflation narrative suggests.
Facts & figures
Fed Funds Rate 2006-2026
© GIS
What monetary policy is trying to do
To better understand the likely fiscal and monetary outlook, it helps to start with first principles. The ultimate goal of monetary policy is to influence the money supply. Everything else (interest rates, reserve requirements, asset purchases) is instrumental; they are levers, not destinations.
Central banks have several levers available: They can change the quantity of bank reserves through open market operations, adjust reserve requirements, alter the discount rate or deploy large-scale asset purchases.
Before 2008, the Federal Reserve relied primarily on the first lever, market operations. It targeted the federal funds rate (the overnight rate at which banks lend reserves to each other) through modest open market operations. The elegant feature of this approach was that, in a world of scarce reserves, the rate and the quantity moved together. Tighten the supply of reserves and the federal funds rate rises automatically. One instrument, two effects, clean transmission from the Fed’s desk to bank lending and to the broader economy.
That world no longer exists.
How QE changed the operating system
The 2008 financial crisis forced the Fed into territory it had never seriously mapped. To stabilize collapsing financial markets, it purchased mortgage-backed securities and Treasury bonds on an extraordinary scale, eventually flooding the banking system with trillions of dollars in excess reserves. The scarce-reserve system gave way to an abundant-reserve system in which the old transmission mechanism stopped functioning as designed.
Then Fed Chair Ben Bernanke’s solution was to pay banks interest on the reserves they held at the Fed. The Interest on Reserve Balances (IORB) gave banks a risk-free return for parking excess reserves with the central bank rather than lending them out, deliberately preventing QE money from hitting the real economy and causing inflation during the bailouts of too-big-to-fail banks. It worked. Inflation did not materialize in 2009 or 2010. The quantitative easing money sat largely inert.
But the central bankers never withdrew the mechanism. What began as an emergency tool became the structural foundation of how the Fed operates. IORB is now the floor of the Fed’s rate corridor (the range central banks use to guide short-term market interest rates toward a central bank’s target policy rate). This new modus operandi has a straightforward implication that rarely gets discussed: It is a standing payment to banks for not lending to the real economy.
This is where the abundant-reserve system creates a genuine problem for monetary transmission. In the old scarce-reserve world, changing the quantity of reserves changed the incentive to lend almost automatically. In the abundant-reserve world, the Fed controls the federal funds rate but has lost clean control of its impact on lending. The two variables that once moved in lockstep now move independently. In this context, a central bank can raise interest rates without changing the quantity of reserves (and the other way around).
The result is a transmission mechanism that still works directionally; raise rates enough and credit eventually tightens, but with looser, longer and more erratic lags than before. The Fed is steering with a wheel that has more play in it than the instrument panel suggests.
In Europe, the ECB faces an additional complication that the Fed does not. With 21 eurozone member states running divergent fiscal paths, a single policy rate does not transmit uniformly across the currency area. When the ECB raised rates aggressively in 2022 and 2023, spreads between German and Italian bonds widened, a sign that the same rate increase was hitting different economies with very differing force. The ECB’s Transmission Protection Instrument (TPI), a tool implemented in July 2022 to ensure the monetary policy stance is transmitted smoothly across all euro area countries, is essentially an admission built into policy architecture: The standard tool requires supplementation to function.
When monetary transmission weakens, central banks compensate by reaching for tools with more direct impact. During the Covid-19 pandemic, the Fed launched lending facilities targeting specific sectors; the ECB deployed Targeted Longer-Term Refinancing Operations, channeling cheap credit toward particular borrowers.
These are not monetary policy instruments in the traditional sense. Monetary policy adjusts the price level through aggregate changes in the money supply; ideally producing no real effects. But what these non-traditional facilities do is allocate resources by directing credit toward some sectors and away from others. That is, by definition, fiscal policy. Central banks conducting such operations is a symptom of broken transmission, not a fix for it. And it carries a cost: Every step into resource allocation erodes the institutional separation between monetary and fiscal authority that makes central bank credibility possible in the first place.
Why tighter reserves are unlikely
Central banks have grown genuinely comfortable with abundant reserves. They view large reserve buffers as a financial stability feature: Banks with ample reserves are less vulnerable to liquidity shocks. There is something to this argument. But the collapse of Silicon Valley Bank in 2023 because of concentrated interest rate risk complicates this reading. Abundant reserves did not prevent the problem; they changed its shape. The stability argument is more complex and less reliable than the comfort zone theory assumes.
The political obstacle is even more stubborn. Shrinking a central bank balance sheet means selling bonds into the market, pushing yields up and making deficit financing more expensive. This, in turn, imposes a direct cost to governments running structural deficits of 6 or 7 percent of gross domestic product, as both the U.S. and several major eurozone members have done in recent non-crisis years.
Governments have every incentive to prefer central banks that sit on large bond portfolios and keep long-term yields suppressed. The fiscal backdrop does not cause the abundant-reserve system, but it creates a powerful political economy against dismantling it. Recent White House strategy concerning the Federal Reserve is a harbinger of the potential loss of central bank independence in the near future.
Monetary policy became subservient to politics
The laws of monetary economics did not break. That point is worth stating clearly. The alternative interpretation, that money no longer matters, that deficits can be financed without consequence, that central banks have lost all grip on the price level, is simply wrong.
What changed is the instrument.
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Mr. Bernanke introduced IORB in 2008 to solve a short-run problem – and it worked. But the solution became the structure. Now, 18 years later, the Fed and ECB operate in a world defined by that emergency choice, with balance sheets that were never normalized and transmission mechanisms that work less cleanly than the pre-2008 playbook assumed.
The weakened connection between instruments and monetary policy effects leads to the creation of alternative instruments and central bankers stepping into the realm of fiscal policy.
Later is better than never in terms of returning to a historically normal and institutionally constrained monetary policy regime.
Scenarios
Likely: Abundant reserves remain the new normal
The more probable path is that abundant reserves remain and the implications for monetary policy effectiveness are significant. Several factors point in this direction.
Central banks view large reserve buffers as a financial stability feature; a preference now embedded in institutional culture, not just crisis response. IORB has become structurally convenient during non-crisis times: It is easier to move rates without pushing reserves outside their comfort zone. Fiscal pressure makes exit politically toxic, as the larger the sovereign debt load, the more governments depend on suppressed long-term yields that a large central bank balance sheet helps maintain.
The central bank drift into quasi-fiscal operations creates its own institutional inertia; targeted lending programs build constituencies and precedents that are difficult to unwind. There is no external forcing mechanism. Unlike exchange rate crises or hyperinflation episodes, erratic transmission lags do not create an acute crisis that compels reform. The problem is chronic, not acute, and chronic problems rarely get fixed.
The main consequence of this scenario is a continuous blurring of the distinction between monetary and fiscal policy. Targeted credit allocation by a monetary authority belongs in the realm of fiscal policy. Channeling central bank nominal shocks through the Treasury is an interference in central bank independence and monetary policy execution. The normalization of this trend can erode central bank independence even in developed countries.
Unlikely: The instrument gets restored
A return to scarce-reserve operations is theoretically coherent and would solve the transmission problem directly. Yet central banks have grown used to the abundant-reserve system and show no appetite for the volatility a scarce-reserve exit would entail in the short run. Shrinking the balance sheet raises sovereign borrowing costs: a direct fiscal hit to governments running structural deficits.
Reserve requirements were abolished quietly in 2020 with little debate; there is no serious institutional conversation about reviving them as an active tool. A genuine exit would require coordinated willingness from both central banks and fiscal authorities. That alignment does not currently exist on either side of the Atlantic.
This scenario would bring back an easier setting to reinforce central bank independence. However, it may produce some fiscal costs if central banks are less willing to accommodate issuance of new Treasury bonds. Moving in this direction will highlight the role of monetary authorities, bringing social and political capital to the “experts,” contributing to counterbalance the political power of policymakers in the government.
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