Reevaluating Central Banking: Insights from Ricardo at LSE

The event is introduced by a professor at the London School of Economics (LSE), who requests attendees to turn off their mobile phones and mentions a Twitter hashtag, 'Elysee rice', for the event. A video podcast of the lecture will be available on the LSE events page, followed by a Q&A session.

The professor expresses genuine pleasure in introducing Ricardo, the guest speaker, highlighting his impressive academic background, including a PhD from Harvard and positions at Princeton and Columbia. The LSE faculty and students are thrilled to have him back in Europe, emphasizing his dual role as an exceptional teacher and researcher who bridges the gap between academia and policy.

Ricardo is delivering the inaugural lecture as the first A.W. Phillips Professor at LSE, a title honoring William Phillips, a notable academic known for the Phillips curve. The professor reflects on Phillips' contributions to macroeconomics, including his development of early computer models and his experiences as a prisoner of war during World War II, where he innovatively built a secret radio and a water boiler.

Ricardo expresses gratitude for the opportunity to give the inaugural lecture, sharing his excitement about the presence of students, especially during exam time. He hopes that the lecture will connect classroom learning with real-world research applications, while humorously anticipating feedback from his wife regarding the event.

The discussion begins with an introduction to central banking, emphasizing the concept of 'normalization' in monetary policy. The speaker references the recent swearing-in of the new chairman of the Federal Reserve, highlighting his mandate to gradually normalize policy to improve global conditions. This notion of normalization is prevalent among policymakers and institutions like the IMF, yet the definition of what constitutes 'normal' remains ambiguous.

The speaker delves into the historical origins of major central banks, starting with the Bank of England, founded in 1694 by John Montagu. Initially established to issue public debt following a war with France, its mandate evolved to managing national debt. The narrative continues with the Bank of France, created in 1716 under the influence of Scottish thinker John Law, who recognized the profitability of banking and proposed a state monopoly on banking operations, leading to significant monetary inflation due to excessive money printing.

The discussion shifts to the Banco do Brasil, established nearly a century later by Prince Regent João VI of Brazil. This bank was designed to serve as the government's financial institution, managing deposits and loans for royal projects, including castle constructions. Notably, it held monopolies on the sales of ivory and diamonds, acting as an agent of the government. The speaker notes that the Bank of Brazil has transitioned into a fully private bank since its inception.

The discussion begins with the evolution of central banks, highlighting the creation of the Bank of Japan during the Meiji Restoration. This establishment aimed to unify Japan by eliminating regional currencies and creating a national currency, essential for forming a cohesive Japanese identity. The speaker notes that the Bank of Japan was crucial in transitioning from local feudal currencies to a standardized national money.

In 1913, the Federal Reserve was established in the United States to address the banking crises that plagued the country for 30 years. It served as a clearinghouse for banks, facilitating the exchange of liabilities among them. The speaker explains that the Federal Reserve's role was to ensure that bank notes issued by different banks would be honored, thus preventing banking crises and maintaining trust in the financial system.

The Hong Kong Monetary Authority was created for a distinct purpose: to manage foreign currency reserves and issue a domestic currency fully backed by these reserves. The speaker emphasizes that this authority plays a critical role in maintaining the stability of Hong Kong's financial system by managing the government's foreign currency holdings.

The speaker reflects on the future role of central banks, particularly the Bank of England, suggesting it should focus on managing national debt, generating funds for public spending, and enforcing national currency. The speaker argues that central banks should also act as clearinghouses for transactions and manage foreign currency holdings, ensuring that they remain relevant in a changing financial landscape. This vision contrasts with the traditional view of central banks, which the speaker believes should evolve to meet contemporary challenges.

The speaker concludes by discussing the concept of 'normal' in the context of central banking. They suggest that 'normal' refers to the state of central banks before the financial landscape became complex, particularly around 2000 to 2007. The speaker uses the Bank of England as an example, noting that its balance sheet was stable, primarily consisting of currency liabilities, which reflects a more traditional and less tumultuous banking environment.

The discussion highlights the nature of bank reserves, which were typically minimal, primarily meeting regulatory requirements. Banks preferred to hold higher-yielding assets, such as short-maturity Treasuries and other investments like gold or foreign currency. The Bank of England maintained a stable balance sheet until 2007, with limited discount window loans and a small amount of reserves.

The monetary policy committee of the Bank of England targeted interbank short-term rates, adjusting the supply of reserves to ensure market equilibrium. This involved issuing or withdrawing reserves and buying government bonds to maintain the target rate. The deposit facility rate was set below the interbank rate, and the lending facility, or discount window, was rarely utilized due to the stigma attached to its use.

The Bank of England operated under a clear mandate to achieve inflation targets while ensuring stable employment and growth. This mandate was reaffirmed annually, with the last one signed by Chancellor Gordon Brown and Governor Mervyn King. The bank communicated its independence by setting interest rates based on inflation forecasts, while also expressing concerns about fiscal policy's impact on its objectives.

The discussion contrasts the normal monetary policy environment from 1987 to 2007 with the extraordinary measures taken during the financial crisis. The Federal Reserve expanded its balance sheet significantly, initiating various funding programs, purchasing agency debt, and mortgage-backed securities, which marked a departure from previous practices.

The Federal Reserve's reserves increased dramatically from zero to $860 billion, alongside the introduction of new liquidity facilities. These included the term auction credit, which provided anonymity for a few days, and a commercial paper funding facility allowing borrowing against collateral other than government bonds. Additionally, the Fed implemented longer-duration loans to banks through the Term Securities Lending Facility (TSLF), moving beyond the standard one-week or 28-day discount window loans.

The Federal Reserve began paying interest on reserves as interest rates approached zero, shifting its policy communication strategy. Instead of focusing solely on immediate interest rate changes, the Fed started to guide market expectations regarding future interest rates, particularly looking 24 months ahead. This marked a significant change in how monetary policy was evaluated, emphasizing anticipated actions over historical rates.

The communication style of central banks evolved significantly, with the Bank of England's approach expanding from brief statements about interest rates and inflation targets to comprehensive discussions on financial stability and macroprudential goals. This shift aimed to provide clarity on future policy directions and balance sheet management, reflecting a more proactive stance in addressing economic stability.

The speaker emphasized the need to rethink the concept of a 'new normal' in central banking, advocating for a focus on ideal practices rather than historical precedents. Over the past decade, the central banking landscape has shifted from conventional to extraordinary measures, providing a unique opportunity for experimentation and learning. This experimentation has yielded valuable insights into effective central banking practices, informed by both historical data and recent experiences.

The speaker outlined their research focus over the past five years, which has centered on understanding the implications of recent central banking experiments. They intend to summarize findings related to the new conventional balance sheet, liquidity programs, monetary policy rates, and communication strategies, aiming to redefine what a modern central bank should embody.

The discussion on the new conventional balance sheet began with an analysis of the Federal Reserve's liabilities. The Fed's currency supply, which had been relatively stable, saw a slight increase post-2009 as public demand for dollars grew. This shift in demand and the subsequent changes in the Fed's balance sheet are critical to understanding the evolving role of central banks in the current economic landscape.

The discussion begins with a claim that currency is becoming obsolete, yet the speaker counters this by stating that the amount of dollars in circulation has actually increased. Many individuals outside the U.S. are now choosing to store dollars, akin to stashing them in a mattress, indicating a growing preference for holding dollars rather than using them for transactions.

A significant change noted is the rise in reserves held by banks at central banks, which surged from nearly zero to approximately three trillion dollars. This shift was facilitated by central banks, such as the Bank of England, offering interest on these reserves, which incentivized banks to hold deposits rather than invest in bonds.

The speaker explains that as reserves increased, the interest rates on these reserves became aligned with private market rates, leading to a situation where the interbank rate equaled the rate on deposits at central banks. This phenomenon, termed 'satiation,' indicates that banks were indifferent to holding more reserves, as their demand for reserves was met without affecting the price.

Post-2009, the issuance of additional reserves by central banks did not lead to inflationary pressures, despite a significant increase in the monetary base. The speaker emphasizes that even with a tripling of reserves, inflation remained stable at around 1%. This observation is supported by basic econometric analysis, suggesting that the relationship between reserve levels and inflation is negligible.

To further investigate inflation expectations, the speaker proposes conducting an event study to compare expected inflation rates before and after significant policy changes or speeches. This method aims to analyze how market expectations of inflation respond to central bank actions, providing insights into the effectiveness of monetary policy.

The discussion begins with an analysis of inflation expectations in the market, particularly before and after the issuance of reserves. It is noted that despite significant reserve issuance, such as the 1 trillion mentioned, there was little change in inflation expectations. The speaker reflects on the lessons learned regarding the relationship between reserve issuance and inflation, emphasizing that it is not only feasible for central banking to maintain inflation control but also desirable.

The speaker elaborates on the advantages of setting a specific lower bound for interest rates rather than targeting a policy rate. This approach allows for more precise control over inflation, as it eliminates variability around the interest rates. The discussion highlights the importance of understanding how changes in interest rates affect the risk premium that banks apply when setting their lending rates, which is now less influenced by liquidity premiums due to banks being satiated with reserves.

Frequent demand shocks and liquidity crises, which previously posed significant challenges for monetary policy, are now less impactful. The speaker notes that as long as the demand for liquidity remains within a certain range, it does not affect monetary policy or inflation control. The horizontal nature of the liquidity demand curve indicates that shifts in demand do not necessitate adjustments in monetary policy.

The speaker discusses the global scarcity of safe assets, particularly government bonds, which have become increasingly valuable as collateral. This scarcity has led to low interest rates across all maturities of government bonds, distorting financial markets. Reserves are presented as a safer asset than government bonds, and their use in payments and liquidity management by firms could potentially free up more government bonds for collateral purposes.

The concept of paying interest on reserves is highlighted as a significant economic strategy, often referred to as the Friedman rule. The speaker argues that if reserves can be issued at zero marginal cost, there is no reason not to satiate the market for reserves. This approach could effectively drive the cost of liquidity to zero by aligning interbank interest rates with deposit rates, presenting a unique opportunity for economic efficiency.

The speaker discusses the concept of digital money, emphasizing that it has been around for over a hundred years. They explain that reserves, such as those held by banks like Barclays, are essentially digital entries in an Excel sheet. For instance, if Barclays has 100 million and adds 100 million, it simply reflects a digital transaction, illustrating the nature of digital money.

The speaker proposes the idea of allowing citizens to have deposit accounts at the central bank, similar to how banks currently operate. They argue that the existing infrastructure could support this, and digital money could be created instantly if there is a sufficient market for reserves. The discussion highlights the need for a system where digital money is accessible to the public, not just banks.

The speaker outlines a potential approach for the Bank of England's monetary policy, suggesting that it could involve announcing interest rates on reserves and deposits simultaneously. They advocate for setting the target interbank rate equal to the deposit rate, which would streamline operations and ensure that the monetary policy committee (MPC) can focus on maintaining this balance without constant debates over the size of the balance sheet.

The speaker emphasizes that the management of the central bank's balance sheet should become a straightforward operational procedure rather than a topic of debate in MPC meetings. They suggest that the markets team should ensure that the supply of reserves meets the demand, allowing for a more efficient monetary policy that focuses on interest rates rather than complex balance sheet adjustments.

The discussion shifts to the nature of the central bank's assets, particularly short-term Treasuries. The speaker argues that these assets closely match the properties of reserves, as they share similar maturities and interest rates. This alignment means that the central bank's operations, such as issuing reserves to buy Treasuries, do not significantly alter the stance of monetary policy or disrupt market outcomes, reinforcing the idea of government liabilities.

The discussion highlights that the central bank's profits are derived from the gap between the one-year rate and the overnight rate, which is typically close to zero but almost always positive. This profit remains steady and manageable, regardless of whether the balance sheet grows or shrinks, thus preventing policymakers from being tempted by excessive policy plans.

A critical distinction is made between Treasury liabilities and central bank liabilities. While both represent government debt, central bank reserves are exclusively held by banks, and reserves serve as the unit of account in the economy. The speaker emphasizes that a pound is always a pound, meaning there is no default risk on reserves, unlike government bonds, which can default, leading to potential losses for bondholders.

In a fiscal crisis, the risk of government default becomes significant, prompting the use of quantitative easing (QE) to buy short-term government bonds. This action transfers risk from banks to non-bank holders of government bonds, providing banks with a riskless asset in place of a risky one. The speaker notes that QE increases the supply of safe assets in the economy, as reserves are default-free, which becomes particularly relevant during fiscal crises.

The potential for central bank losses arises when it holds long-term bonds funded by short-term reserves, exposing it to duration risk. If the yield curve flattens, the central bank profits, but if it steepens, it incurs losses. Additionally, the speaker points out that central banks face risks when buying foreign assets, as unexpected currency appreciation can diminish the value of their foreign reserves, leading to significant financial losses.

Experts are currently devising accounting schemes to obscure significant losses incurred by turbine sets. They employ methods such as marking assets to book value instead of market value, arguing that holding bonds to maturity negates losses despite fluctuations in the yield curve. These deferred accounts and other strategies are essentially tactics to manipulate the flow of resources over time, ultimately reducing the amount owed to the Treasury and potentially leading to a negative balance.

The speaker, alongside co-author Robert Hall, presents two critical theorems regarding central bank solvency. The first theorem posits that a central bank remains solvent as long as it pays its net income as dividends. If it incurs losses, the Treasury can provide a negative dividend to cover these losses, ensuring the central bank's solvency, akin to other government departments that receive fiscal support. The second theorem highlights a scenario where a central bank, like the European Central Bank, experiences negative net income without receiving Treasury transfers, leading to a high probability of eventual insolvency due to the lack of capital support.

The speaker elaborates on the concept of central bank insolvency, clarifying that it does not align with traditional bankruptcy definitions. Instead, insolvency in economic terms refers to a central bank's inability to meet its liabilities, which cannot resemble a Ponzi scheme. If a central bank's liabilities, represented as reserves, lose their value and are no longer held by banks, it signifies insolvency. This situation can manifest as hyperinflation, where the central bank's reserves become worthless, indicating a failure in maintaining the value of its issued currency.

The discussion highlights the challenges faced by monetary policy, particularly regarding capital losses and the potential for a central bank to operate like a Ponzi scheme if it cannot retire its reserves. The speaker emphasizes the importance of the monetary policy committee's (MPC) ability to manage the balance sheet size to maintain interest rate targets, while also acknowledging the need for unconventional policies like quantitative easing (QE) during exceptional times.

Quantitative easing is described as a policy where the MPC takes control of the balance sheet size, focusing not on the amount of reserves issued but on the composition of assets purchased. The speaker stresses that QE should prioritize buying short-term Treasuries and highlights the importance of understanding the income risks associated with these assets, as well as the fiscal support necessary to mitigate potential losses.

The speaker references the Bank of England's former governor, Mervyn King, who secured a letter of indemnity from the Treasury before engaging in QE, ensuring fiscal support for any losses incurred. In contrast, the European Central Bank (ECB) lacks such a guarantee and must negotiate recapitalization during Eurogroup summits, which complicates its ability to implement QE effectively.

The speaker warns against the misconception that independent central banks can never go bankrupt or insolvent, arguing that such beliefs are fallacies. They explain that insolvency can occur through hyperinflation and emphasize the need for central banks to operate within budget constraints, focusing on covering operational costs rather than generating dividends for government finances.

The establishment of dollar swap lines among central banks is discussed, particularly how the Federal Reserve lends dollars to the Bank of England, which in turn lends to UK banks. The mechanics of these swap lines are explained, including the collateral process and the credit risk involved. The speaker compares swap lines to the discount window for US banks, noting their significant impact on deviations from covered interest parity.

Barclays is navigating the need to convert pounds to dollars to repay the Bank of England, which involves managing exchange rate risks. To mitigate this risk, Barclays can purchase a forward contract to lock in the exchange rate for converting dollars back to pounds. This strategy is rooted in the principle of covered interest parity, which suggests that interest rate differentials between countries should equalize the costs of borrowing in different currencies. However, over the past decade, this principle has not held consistently, leading to increased costs for hedging against currency fluctuations.

The discussion highlights a significant change in November 2011 when the Federal Reserve reduced the cost of its swap lines by 50 basis points. This adjustment had a notable effect on the cost of covered interest parity (CIP) deviations, particularly for currencies with swap line agreements. The reduction in costs led to a decrease in the expenses associated with private market transactions, effectively making it cheaper for banks to hedge against currency risks. This change is illustrated by a comparison of the distribution of forward contract prices before and after the Fed's announcement.

Following the Fed's adjustment to the swap line, Barclays demonstrated a marked shift in its investment strategy. The bank began favoring dollar-denominated corporate bonds over pound-denominated ones, indicating a greater willingness to invest in dollar assets due to the now cheaper insurance against potential funding withdrawals. This shift was evident within days of the Fed's announcement, showcasing how central bank policies can influence bank behavior in international markets.

The analysis concludes that central bank swap lines are crucial for global banks like Barclays, especially when investing in dollar assets. These swap lines serve as a vital alternative to direct dollar access, helping to stabilize markets and prevent fire sales of U.S. assets during times of financial stress. The ability to secure dollars through swap lines enhances banks' confidence in their international investments, thereby supporting overall market stability.

The speaker discusses the critical need for UK banks, which have significant euro business, to secure euro funding in the wake of Brexit. They emphasize the importance of establishing mechanisms, such as swap lines between the Bank of England and the European Central Bank (ECB), to ensure access to euros. This is highlighted as a vital aspect of the new normal for the Bank of England.

The speaker presents a new perspective on the Bank of England's balance sheet, noting that while currency is stable and not particularly interesting, deposits are crucial. They suggest that the size of deposits should be endogenous, using interest rates as a primary tool for monetary policy. The speaker proposes allowing individuals, like Ricardo, to open accounts at the Bank of England, thereby enhancing the role of digital currency and managing risks associated with fiscal crises.

Transitioning to the topic of interest rates, the speaker asserts that price control is not merely about money supply or currency reserves. They argue that inflation dynamics are complex, as evidenced by the stability of currency despite significant increases in reserves. The speaker critiques traditional monetary theories, particularly the MV=PY equation, and emphasizes the effectiveness of independent central banks in managing nominal interest rates based on expected inflation and economic shocks, referencing the Taylor rule as a successful feedback mechanism.

The speaker highlights the impressive performance of the Bank of England over the past 20 years, showcasing its ability to maintain an average inflation rate of around 2% with minimal volatility. They argue against the notion of abandoning the independence of the Bank of England, pointing to historical failures of other monetary regimes. The speaker uses this data to advocate for the continued application of the Fisher equation in economic policy, reinforcing the importance of independent central banking in achieving stable economic outcomes.

The speaker reflects on the inflation trends post-2010, noting that inflation across nineteen advanced economies remained relatively stable, averaging only a 50 basis point change. Despite various commodity price shocks and significant policy changes, inflation volatility was low, which was seen as a success. However, the speaker highlights a disconnect between theoretical expectations and actual outcomes, particularly regarding interest rates and inflation expectations.

The discussion shifts to the relationship between public debt and inflation, where the speaker points out that despite a substantial increase in public debt, there was no corresponding expectation of hyperinflation. This observation raises questions about the effectiveness of traditional economic theories that suggest high public debt should lead to inflationary pressures.

The speaker expresses a decrease in confidence regarding the determinants of inflation, contrasting the perspectives of policymakers and academics. While policymakers may celebrate the stability of inflation rates, academics are left questioning the underlying mechanisms that control inflation, indicating a growing uncertainty in economic models.

An innovation in central banking has been the increased focus on long-term interest rates. The speaker notes that this approach is not entirely new, referencing historical instances where central banks struggled to control inflation when targeting long-term rates, such as the Bank of England in the 1950s and the Federal Reserve in the late 1940s. The speaker warns of potential 'high inflation traps' that can arise from this focus.

The speaker illustrates the dangers of targeting long-term rates by referencing U.S. monetary history from 1947 to 1950, where expectations of the Korean War led to rising interest rates and budget deficits. The central bank's failure to adjust nominal interest rates in response to these expectations resulted in a loss of control over inflation, demonstrating the complexities and risks associated with long-term rate targeting.

The discussion begins with the expectation of future inflation, highlighting how rising inflation can become self-fulfilling. The speaker notes that if nominal rates remain pegged, high inflation is likely to result. This sets the stage for a deeper exploration of how central banks can influence inflation through interest rate adjustments.

The speaker explains that while central banks typically set short-term rates, they have the capability to set longer-term rates such as the two-year, five-year, or ten-year rates. The rationale for focusing on the overnight rate is tied to the nature of overnight deposits. However, the speaker emphasizes that controlling longer-term rates can lead to complications, particularly regarding term premiums and their impact on inflation.

A critical distinction is made regarding the relationship between short-term and long-term rates. Lowering short-term rates does not directly push up inflation; rather, it is the steepening of the yield curve—achieved by lowering short-term rates relative to long-term rates—that can lead to higher inflation. The speaker argues that if central banks wish to raise inflation, they should consider increasing long-term rates instead.

The speaker references the Bank of Japan's strategy of setting both short-term and long-term rates, which targets the safe rate and incorporates risk premiums. This approach signals how inflation may respond to future shocks, illustrating a proactive stance in managing inflation expectations through yield curve control.

The discussion shifts to the new conventional interest rate policy, where the Monetary Policy Committee (MPC) sets a positive interest rate that adjusts to keep short-term rates anchored. The speaker mentions the importance of liquidity management and the potential need for unconventional policies, especially when overnight rates are at zero, to effectively control inflation risk premiums.

Reflecting on the past decade, the speaker shares insights on the growth of U.S. public debt, noting a significant increase in privately held public debt since 2015. As debt levels rise, the maturity of this debt tends to shorten, complicating efforts to inflate it away. The speaker highlights that expected inflation remains relatively stable, indicating challenges in managing debt through inflationary measures.

The speaker discusses the challenges of inflating away short-term debt, emphasizing that if inflation occurs only after a year, it is too late to mitigate the debt that matures in six months. Historical analysis reveals that countries facing difficulties in inflating their debt often resort to financial repression, which involves taxing banks or converting short-term debt into long-term obligations. This method effectively allows the financial system to inflate away liabilities, particularly when central banks lose independence and the Treasury gains control.

The speaker highlights a striking example from U.S. history in the 1970s, where the government engaged in financial repression by approving Regulation Q, which exempted banks from paying interest on deposits. This led to significant losses for depositors, particularly those with checking accounts, as inflation reached 8% while they earned nothing on their savings. The economist Jim Tobin noted this trend, pointing out that the most vulnerable members of society were disproportionately affected by these policies.

The speaker critiques the focus of economists on measuring government purchase multipliers, which assess how much output increases with government spending, such as building bridges. This obsession, rooted in Keynesian economics, overlooks the reality that many OECD countries have engaged in fiscal expansions without significant changes in government spending (Delta G). The speaker argues that policymakers should shift their attention to how output (Delta Y) changes, especially during recessions, rather than fixating on multipliers.

The speaker warns against the misconception that a high multiplier justifies more active fiscal policy. He explains that an active monetary policy can lead to a steeper Phillips curve, resulting in a lower multiplier effect. This suggests that policymakers should be cautious in assuming that high multipliers equate to effective fiscal interventions, as the dynamics of monetary policy can significantly alter economic outcomes.

The speaker discusses three types of fiscal policy: active policy, deficit policy, and automatic stabilizers. Active policy suggests increasing the deficit by a certain percentage during a recession, akin to a Taylor rule, where a 3% output gap leads to a 3% increase in deficit. Deficit policy focuses on how quickly to revert debt levels after engaging in active fiscal policy, while automatic stabilizers include micro tax and transfer systems that provide social insurance, such as unemployment insurance and progressive tax systems, which grow during recessions.

The speaker emphasizes that a more generous fiscal system, which redistributes more during recessions, reduces individual risk exposure. This leads to less precautionary saving, thereby mitigating the recession's impact. When monetary policy is constrained, fiscal policy, particularly automatic stabilizers, becomes crucial as they help maintain equilibrium real interest rates and reduce the likelihood of hitting the zero lower bound.

The speaker argues for the necessity of central banks to maintain independence in macro-prudential policy to avoid financial repression, especially when the government is under pressure to pay its debts. He cites John Williams, the new president of the New York Fed, who advocates for stronger, predictable systemic adjustments rather than discretionary policies to address the zero lower bound problem.

In concluding remarks, the speaker outlines a vision for new conventional monetary policy that includes a focus on balance sheet policy, liquidity support, and the need for long-term interest rate targets. He warns against excessive market regulation, which can lead to repression, and stresses the importance of enhancing the safety net and automatic stabilizers to stabilize the economy and reduce the frequency of zero lower bound occurrences.

The speaker opens the floor for a Q&A session, inviting participants to combine their questions and wait for the microphone. He acknowledges a question regarding inflation's exogenous nature, suggesting that it may not align with traditional teachings, and hints at the complexities of the Phillips curve in economic discussions.

The discussion begins with the role of a Monetary Authority, specifically a central bank, in targeting inflation, which is aimed at a rate of around 2%. The speaker notes that there is no empirical correlation between inflation and economic fundamentals, suggesting an identification issue rather than a failure of the Phillips curve. This raises questions about the effectiveness of traditional economic theories in the current context.

The speaker expresses concern about the implications of digitalization for banking, particularly if central banks hold all public deposits. They question who will perform the essential role of intermediation, as banks are traditionally seen as better at assessing loan risks than central banks. This concern leads to a broader discussion about the second welfare theorem and the government's role in covering losses, highlighting skepticism about the realism of such commitments.

Responding to a question from Silvana, the speaker reflects on their diminishing confidence in previously held economic beliefs due to recent experiences. They clarify that while they do not believe the Phillips curve has collapsed, they acknowledge that the last decade has raised doubts about the certainty of various economic principles, including the relationship between public debt and inflation, and the independence of central banks.

The speaker elaborates on the Phillips curve, noting that while inflation targeting has been successful, the slope of the curve appears to have changed. They discuss the impact of inflation shocks, particularly from commodity prices, and how these factors have not led them to reject the Phillips curve but rather to question their previous confidence in it. They emphasize the need for a nuanced understanding of inflation dynamics.

The speaker explains the traditional intermediation process of banks, which involves collecting short-term deposits and making long-term loans. They highlight that a digital account at the Bank of England would only offer interest on reserves, which would be lower than what commercial banks like Barclays provide. This situation suggests that while the Bank of England could offer a safe deposit option, it would not eliminate the role of banks in intermediation, as banks would still need to offer competitive rates to attract deposits.

The banking sector incurs significant costs to attract deposits, with estimates suggesting that it costs banks approximately 3 to 4 pence for every pound deposited. Despite the Bank of England's potential to accept deposits, it is unlikely that a substantial portion of the English population would transfer their accounts, primarily due to the lack of effective marketing strategies by the Bank.

For over 30 years, purchasing U.S. government bonds has been streamlined through platforms like TreasuryDirect.gov, allowing citizens to buy bonds online in about 10 minutes. However, 99% of government bonds are still acquired through intermediaries such as pension funds or brokers, highlighting the persistent reliance on traditional brokerage services despite the availability of direct purchasing options.

Historically, the Federal Reserve maintained a risk-free balance sheet, primarily holding short-term Treasuries and reserves, resulting in a zero probability of net income loss. However, as the Fed has begun to take on some risk, current estimates indicate that this risk remains minimal and manageable within the existing fiscal backing framework. The discussion emphasizes the need for stress testing to evaluate the adequacy of fiscal support as the Fed navigates riskier balance sheets.

The session concluded at 8:00 PM, with a note of gratitude extended to the speakers for their insights on banking costs, government bond purchases, and the Federal Reserve's risk management strategies.