Global central banks grapple with unprecedented scale and mounting political pressures

Central banks were built for moments of upheaval, and the latest era of instability may be testing the limits of what they can still achieve. Their original mandates were forged in crises: Sweden’s Riksbank was created in 1668 after a banking collapse, the Bank of England in 1694 to help finance war, and the US Federal Reserve in 1913 to steady a monetary system prone to panics and liquidity shocks.

That history matters because the policy toolkit has changed dramatically. In the age of fiat money, central banks create reserves largely through the purchase of government debt, using their balance sheets to influence liquidity, interest rates and, by extension, the wider economy. According to the Federal Reserve’s own recent historical review of its balance sheet, the institution’s assets have expanded and contracted in line with major policy shifts, from the end of the gold standard to the post-2008 era of quantitative easing.

The current scale of central bank balance sheets is striking. The Fed’s balance sheet now stands at roughly 24% of US GDP, close to the level reached at the end of the Second World War, when wartime financing pushed it to a similar share of the economy. The European Central Bank’s balance sheet swelled sharply during the pandemic before easing back, while the Bank of Japan remains the most extreme outlier among major central banks after years of aggressive asset buying under its quantitative and qualitative easing programmes.

This is where the debate becomes more political than technical. With public borrowing rising and fiscal deficits widening, central banks are increasingly being asked to absorb the consequences of government spending rather than merely smooth cyclical shocks. That creates a difficult trade-off: tightening policy to curb inflation risks destabilising debt markets and slowing growth, while leaving policy too loose risks embedding higher prices.

The prospect of Kevin Warsh taking over as Fed chair from Jerome Powell has sharpened that discussion. Warsh, who served on the Fed board during the 2008 financial crisis, has argued that “inflation is a choice”, a formulation that reflects a more sceptical view of how much central banks can influence prices through communication and interest-rate guidance alone. He has also favoured the trimmed mean PCE measure over the Fed’s standard core PCE index, which tends to strip out more of the short-term noise and can point to a softer underlying inflation picture.

That matters because the inflation gauge used by policymakers can shape expectations about the pace of rate moves. A lower reading would tend to support the case for a more patient Fed, and markets have already shown signs of unease, with 10-year Treasury yields moving above 4.6%. For the US Treasury, that is hardly comfortable: the federal government’s debt burden is now around US$39 trillion, annual interest costs have surpassed US$1 trillion and the deficit remains well above levels the International Monetary Fund considers sustainable.

The broader backdrop is even less forgiving. A rising share of deficits appears to be tied to spending that does not necessarily generate immediate economic pay-off, increasing the risk of stagflation rather than healthy, growth-led disinflation. At the same time, the US economy is becoming more dependent on artificial intelligence investment and a narrow group of large technology companies, even as layoffs spread among white-collar workers and higher borrowing costs weigh on housing, student loans and consumer credit.

That combination leaves central banks facing multiple pressures at once: inflation, growth weakness, financial-market volatility and the risk of de-dollarisation as lenders diversify away from US assets. The IMF has warned that global public debt is headed towards 100% of GDP by 2029, driven largely by the US and China, underlining how closely monetary policy is now tied to fiscal choices.

For policymakers, the hardest lesson may be that rate-setting alone cannot fix a deficit problem. If governments fail to rein in wasteful spending, lift savings and strengthen institutions, central bankers may once again be left to do the least politically attractive thing: wait, tighten, and hope inflation can be forced down without breaking something else.