The turmoil in financial markets has posed hard questions for central banks. Their reputations are now staked on their answers

“THIS is manna. I am blown away. These guys get it.” All decibels and splutters, Jim Cramer, CNBC's markets pundit, was cheering the Federal Reserve's decision on September 18th to cut short-term interest rates by half a percentage point. That bold stroke would bring the credit markets back to life after the nastiest shock in at least a decade. It would, he shrieked, get people to start selling, shopping and hiring. “I could hug these guys,” he yelled. “This is what we wanted.”

Mr Cramer makes a career out of exaggeration. But he is not alone in concluding that the financial world can at last begin to put a miserable summer behind it; and that the turning-point came when the rich economies' central banks showed that they would use interest rates to keep the economic engines roaring. Since the Fed's cut, equity markets have scaled new records, and even junk debt is starting to find a few buyers. Hallelujah! Good job! Lesson learnt! as Mr Cramer might say. The whole ghastly episode was proof that central banks are blessed with great power and that they should use it if need be.

If only life were so simple. In reality, the credit crisis has presented central banks with their greatest challenge since they won the battle against inflation a generation ago. It has cast doubt on how well they have discharged their twin duties as the guardians of financial stability and as the defenders of price stability. It poses questions about whether the almost mystical status that they have acquired over the past two decades can endure—and whether it would be a good thing if it did.

A great deal rests on those questions. A brilliantly inventive generation has harnessed computing power and financial theory to transform the world of finance. Trillion-dollar global markets have sprung up on the back of techniques for converting loans, interest payments, default risk and who knows what else into new securities that could be chopped up and repackaged in mind-boggling combinations, sold and resold. Much good has come of that—and not only fat bonuses on Wall Street and in the City. The most valuable result of the new finance is that more people and businesses have gained access to credit on better terms.

But this summer has shown how far invention has raced ahead of intervention. Vital parts of the new finance take place in lightly supervised markets, as far from the glare of regulators as its practitioners can profitably get. That should be no surprise: regulation imposes costs, restricts innovation and slows people down. Yet, with devastating speed, the crisis spread back into the heart of the most regulated parts of the financial system, the interbank markets and the market for central-bank reserves, which obliged the central banks to provide liquidity. It even caused scares about the stability of banking systems.

Fixing this will not be easy. At one extreme, to ignore regulatory lessons and just bail out the financiers would be to invite an even more severe crisis next time round. At the other, an over-zealous tightening of regulation would extract a vast cost in lost opportunities for the wise use of the new techniques to make people better off. Regulation spawns innovation to avoid it. Perversely, some of what happened this summer was the unintended consequence of previous regulation.

As for financiers, so for the economy as a whole. As chart 1 shows, the Great Inflation of the late 1970s gave way to an age of low, steady inflation thanks in large part to the skill with which central banks learnt to steer policy. The anchoring of inflationary expectations at moderate levels in turn combined with technological change and globalisation to support strong, steady economic growth. And in both America and Europe unemployment fell below the rates at which economists used to think inflation would start to rise.

A question of credibility

Central banks' success in controlling inflation has won them credibility as economic managers. But that credibility is now at risk in two ways. First, those banks, and in particular the Fed, must take some of the blame for their part in stoking the appetite for risk. Monetary policy was too loose for too long, helping to pump up housing markets in America and elsewhere.

The second threat to credibility rests on how central banks use monetary policy to help clear up the credit mess. In America, where growth and jobs are most at risk, Alan Greenspan, chairman of the Fed until last year, has put the chance of recession at more than one in three. Amid the anxiety, interest-rate increases in Canada, Europe and Japan have been shelved.

The central banks have a difficult balance to strike. If policy is too tight, they will be held responsible for creating recessions. If it is too loose, their grip on inflation could slip, as markets and the public cease to believe that prices will remain stable.

The great paradox is that the central banks' mastery of inflation has made the task of keeping financial markets safe all the harder. When people are confident that inflation is low and will remain so, they may be more prepared to take on debt. That leads to an expansion of credit and the pursuit of more exotic rewards by lenders. It feeds price rises in assets such as housing and securities. It encourages excessive risk-taking. If so, how can you contain inflation without sparking occasional but dangerous bouts of insanity in asset markets? That is a riddle likely to test central bankers for a long time to come.

The central banks' unprecedented public standing, which helped them in the fight against inflation, has also proved a double-edged sword. Blind faith that the Fed will always save the day encourages people to take even greater risks. Greed, unless it is reined in by fear, reaches out towards the calamitous moment when the central bankers' defences fail.

Central bankers themselves are realistic about their knowledge and their powers. Donald Kohn, a Fed governor, put it with admirable honesty in December last year: “In informal terms, we are uncertain about where the economy has been, where it is now and where it is going.” But many financial speculators cling to the idea that central banks are omnipotent. For the sake of everyone else, they should be disabused before they venture into even greater excess.