A key role of central banks is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations. The policy frameworks within which central banks operate have been subject to major changes over recent decades.

Since the late 1980s, inflation targeting has emerged as the leading framework for monetary policy. Central banks in Canada, the euro area, the United Kingdom, New Zealand, and elsewhere have introduced an explicit inflation target. Many low-income countries are also making a transition from targeting a monetary aggregate (a measure of the volume of money in circulation) to an inflation targeting framework. More recently, amidst growing concern about eroding policy space in a context of lower equilibrium interest rates and falling inflation expectations, major central banks have been reviewing their monetary policy frameworks

Central banks conduct monetary policy by adjusting the supply of money, generally through open market operations. For instance, a central bank may reduce the amount of money by selling government bonds under a “sale and repurchase” agreement, thereby taking in money from commercial banks. The purpose of such open market operations is to steer short-term interest rates, which in turn influence longer-term rates and overall economic activity. In many countries, especially low-income countries, the monetary transmission mechanism is not as effective as it is in advanced economies. Before moving from monetary to inflation targeting, countries should develop a framework to enable the central bank to target short-term interest rates (paper).

Following the global financial crisis, central banks in advanced economies eased monetary policy by reducing interest rates until short-term rates came close to zero, which limited the option to cut policy rates further (i.e., limited conventional monetary options). With the danger of deflation rising, central banks undertook unconventional monetary policies, including buying long-term bonds (especially in the United States, the United Kingdom, the euro area, and Japan) with the aim of further lowering long term rates and loosening monetary conditions. Some central banks even took short-term rates below zero.

In response to the COVID-19 pandemic, central banks have taken unprecedented policy actions to ease monetary policy across the globe, provide ample liquidity to core funding markets, and maintain the flow of credit. To mitigate stress in currency and local bond markets, many emerging market central banks used foreign exchange interventions and deployed, for the first time, asset purchases programs (see IMF COVID-19 policy tracker).

Foreign exchange regimes and policies
The choice of a monetary framework is closely linked to the choice of an exchange rate regime. A country that has a fixed exchange rate will have limited scope for an independent monetary policy compared with one that has a more flexible exchange rate. Although some countries do not fix the exchange rate, they still try to manage its level, which could involve a tradeoff with the objective of price stability. A fully flexible exchange rate regime supports an effective inflation targeting framework.

Macroprudential policy
The global financial crisis showed that countries need to contain risks to the financial system as a whole with dedicated financial policies. Many central banks that also have a mandate to promote financial stability have upgraded their financial stability functions, including by establishing macroprudential policyframeworks.

Macroprudential policy needs a strong institutional foundation to work effectively. Central banks are well placed to conduct macroprudential policy because they have the capacity to analyze systemic risk. In addition, they are often relatively independent and autonomous. In many countries, legislators have assigned the macroprudential mandate to the central bank or to a dedicated committee within the central bank.

Regardless of the model used to implement macroprudential policy, the institutional setup should be strong enough to counter opposition from the financial industry and political pressures and to establish the legitimacy and accountability of macroprudential policy. It needs to ensure that policymakers are given clear objectives and the necessary legal powers, and to foster cooperation on the part of other supervisory and regulatory agencies (see further Key Aspects of Macroprudential Policy). A dedicated policy process is needed to operationalize this new policy function, by mapping an analysis of systemic vulnerabilities into macroprudential policy action (Staff Guidance Note on Macroprudential Policy).

In response to the COVID-19 pandemic, many countries relaxed macroprudential buffers to complement other policies with the aim of absorbing stresses in the financial system and support the provision of credit to the economy. Such relaxation can be in line with the IMF’s existing framework.