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Central banks risk seeing their feted 'independence' watered down

Their autonomy will prove superfluous in a low-inflation, stagnant world.

Central banks risk seeing their feted 'independence' watered down

September 2019

William Martin is the longest-serving Federal Reserve chief, having served from 1952 when Harry Truman was president to 1970. A few years into the role, Truman saw Martin on a New York street. The president from 1945 to 1953 stared at Martin, called him a “traitor” and walked away.[1] Martin’s betrayal? He prioritised a successful fight against inflation running at an annualised 21% in 1951, rather than help Truman fund the Korean war by ensuring Washington could borrow at 2.5% or less.[2]

Lyndon Johnson, the fourth of Martin’s five presidents, got frustrated with him too. Johnson enacted fiscal stimulus in 1964 only to see the Fed resist his bullying to keep interest rates low. In 1965, Johnson summoned Martin to his Texas ranch where the president “shoved him around his living room, yelling in his face: ‘Boys are dying in Vietnam and Bill Martin doesn’t care.’”[3] When Martin’s final term ended, inflation was 6% and heading to double-digits.

Now President Donald Trump is treating the Fed with similar disrespect. Trump has publicly criticised the “going loco” Fed led by “clueless”[4] “enemy”[5] Jerome Powell about 50 times since mid-2018 over high interest rates and nominated supporters of questionable fit for the Fed’s policy-making board, amid reports he considered sacking his appointee to lead the central bank.[6]

The worry is that Trump is just another menace to the practice whereby central banks set monetary policy to meet inflation and other targets supposedly free of political pressure. Bloomberg counts that 17 central banks faced political interference in 2018.[7] The number includes the European Central Bank that was attacked for radical remedies such as negative rates and for buying government bonds.[8] The Bank of England featured for issuing forecasts unflattering to UK’s future outside the EU – one Conservative MP in 2019 called Governor Mark Carney a “second-tier Canadian politician” engaged in “Project Hysteria”.[9] Conflicts last year between the Reserve Bank of India and the government led to the governor’s resignation. This year, the head of the Central Bank of the Republic of Turkey was sacked over policy disputes.

Many forces are combining to weaken the autonomy of central banks. Populists are targeting central banks because the global financial crisis discredited the neoliberal framework of which their independence is a part.[10] Central banks have been given more tasks, often bank supervision, that come with controversies. Central bankers are commenting on politically sensitive topics such as climate change[11] and gender quotas.[12] Critics claim their asset-buying programs have boosted inequality by inflating asset prices (even when conceding such tactics staved off recessions).

But two other reasons stand out that point to the trend intensifying because they relate to the merits of independent monetary policy as a way to manage economies. The first is the raison d'être for independent central banking is waning; low inflation means politicians have lost their incentive to outsource the blame for higher interest rates. The second is that orthodox monetary policies are exhausted and people realise monetary tools can’t be radicalised much more because they promote risks; namely, they inflate asset prices, hinder lending[13] and squeeze bank profits (which increases the risk of financial instability). To overcome this failure of monetary policy to fire sustainable growth, policymakers are pondering fiscal solutions that would dilute the autonomy of central banks.

Japan’s experience shows how political and economic conditions can force action that curtails central-bank freedom. Many argue the Bank of Japan lost its autonomy in 2013 when it became part of Prime Minister Shinz┼Ź Abe’s drive to refloat Japan’s deflation-ridden economy. A central feature of ‘Abenomics’ is it blurs the distinction between monetary and fiscal policies, which were separated to stop the inflation-prone practice whereby central banks bought government bonds directly from Treasuries to fund fiscal deficits.[14]

As Japan’s fight against deflation shows, the weakening of central-bank autonomy can be an appropriate policy response. But the loss of central-bank autonomy could come at a cost, especially if it’s judged to be due to political pressure rather than economic circumstances. The policy to convince investors and the public that central banks were above the political fray reduced the level of uncertainty in asset prices and instilled public faith that inflation would stay tame, fiat currencies would hold their worth and central banks would act for the common good.[15] If central-bank autonomy were to erode, such investor and public confidence could be hard to restore.

To be sure, most central banks only enjoy a ‘quasi independence’ – some analysts even call central-bank independence a “myth”, however, John Howard might have disagreed when the Reserve Bank of Australia raised rates during the formal campaign of the 2007 election his government lost.[16] Central banks are entwined in politics because they form part of the executive and they often cooperate with Treasuries, as happened in the US during the global financial crisis. Lawmakers set goals for central banks that can be revised any time. They make central bankers report to parliaments. Many central-bank leaders need to maintain public and parliamentary support to ensure their reappointment. The record of ‘apolitical’ central banking has blemishes. The biggest are the global financial crisis and the ECB’s rate increases of 2010 that intensified the eurozone debt crisis.

Whatever their errors or the degree of autonomy, granting central banks independence was an apt political and policy solution when inflation was a threat. Today’s low-inflation, low-growth and high-debt world will likely call on fiscal remedies that erode central-bank autonomy. The faster central banks exhaust their orthodox options, the sooner comes the day when investor and public faith in these solutions is tested.  

Genuine or quasi

German Chancellor Helmut Kohl (1982-1998) wanted a single currency for Europe as his legacy but knew Germans preferred to keep the Deutsche mark. Kohl’s solution was twofold. He created rules around fiscal deficits to assure Germans they would never need to bail out other euro countries. The other was to ensure the ECB be set up without any political oversight to ensure independence to meet its sole goal to control inflation.[17]

The ECB’s treaty-protected independence harked to the establishment of the Bundesbank in 1957 as the world’s first independent central bank as required by Germany’s constitution of 1949.[18] The Bundesbank’s freedom to safeguard price stability become more overt after Bretton Woods collapsed in 1973 and fiat currencies were floated. Essentially, political and policy imperatives drove these developments; namely, to guarantee Germans would never again suffer the hyperinflation of the early 1920s and straight after World War II.

The Fed’s shift to a de facto independence is another outcome of political and economic circumstances. The watershed was the Treasury-Federal Accord of 1951, which ended the role the Fed undertook at the start of World War II to buy government bonds to ensure Washington could borrow cheaply. The Fed emerged from Treasury servitude because the central bank needed to fight the price increases caused by its financing of Washington’s spending on the Korea war. Inflation soared at the time due to the absence of the price controls used in World War II.[19]

The next notable step to quasi autonomy was when the double-digit inflation of the 1970s prompted Congress to pass the Federal Reserve Reform Act of 1977, which tasked the Fed with the goals of price stability, full employment and moderate interest rates.[20] (The last goal, a subjective one, is overlooked and the law is known as the ‘dual mandate’.)

In 1979, Paul Volcker at the start of his eight-year stint as Fed chief used this law to convince the administration of Jimmy Carter that the Fed needed to haul in inflation running at an annualised 11% to ensure full employment over the longer term.

Volcker crushed inflation – though at the cost of the 1981-1982 recession – and his triumph inspired other countries to grant their central banks ‘autonomy’ to control price increases. New Zealand in 1989 became the first country to do so. Canada followed in 1991. Australia, where Paul Keating boasted in 1989 that the RBA was “in his pocket”, did likewise in 1996.[21] The UK followed in 1997 and Japan in 1998.

But now this quasi independence could fray as policymakers confront a low-inflation, even deflationary, world where growth is challenged, debt is high, trade barriers are rising and asset prices are at record highs.[22]

On July 23, the day Boris Johnson became the new leader of the Conservative party, Andy Haldane, the Bank of England’s chief economist, had a warning for the new prime minister. The government can’t expect the “monetary cavalry” to rescue the economy, Haldane said. “A decade ago ... monetary policy was the right prescription. The game has changed. The right medical prescription (now) is fiscal and structural policies.”[23]

As policymakers turn to fiscal policy and executive fiat to promote sustainable more-equitable growth, central bankers might morph into public servants whom Truman would consider loyal and to whom Johnson would be friendly. But investors and the public might trust them less, especially if the loss of autonomy occurs while Trump is tweeting against the Fed.

By Michael Collins, Investment Specialist


[1] Robert L. Hetzel and Ralph F Lynch. ‘The Treasury-Fed accord: A new narrative account.” Federal Reserve Bank of Richmond. Economic quarterly. Winter 2001. Page 52. richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/2001/winter/pdf/hetzel.pdf. For another account, see: Federal Reserve History. ‘From the Treasury-Fed accord to the mid-1960s.’ federalreservehistory.org/essays/treas_fed_accord_to_mid1960s?WT.si_n=Search&WT.si_x=3

[2] For more, see Fed’s. ‘From the Treasury-Fed accord to the mid-1960s.’ Op cit.

[3] Sebastian Mallaby. ‘The man who knew.’ The life and times of Alan Greenspan. Bloomsbury. 2016. Page 104.

[4] Twitter feed of US President Donald Trump. 14 August 2019. twitter.com/realDonaldTrump/status/1161719409804808193

[5] Twitter feed of US President Donald Trump. 23 August 2019. twitter.com/realDonaldTrump/status/1164914610836783104

[6] See Bloomberg News for more than 40 occurrences of Trump berating Fed or Powell from his first public criticism on 19 Julyh 2018 to 31 July 2019. Bloomberg News. ‘Here’s a timeline of all Trump’s key quotes on Powell and the Fed.’ 31 July 2019. Trump said the Fed was “going loco” on 10 October 2018. bloombergquint.com/politics/all-the-trump-quotes-on-powell-as-fed-remains-in-the-firing-line-7. Trump’s Twitter feed (twitter.com/realdonaldtrump) for August shows more than 10 similar taunts.

[7] Bloomberg News. ‘All around the world, central-bank independence is under threat.’ 7 December 2018. bloomberg.com/news/articles/2018-12-07/the-political-heat-is-on-for-central-banks-from-u-s-to-europe

[8] In July, Germany’s constitutional court began a new hearing about the legality of the ECB’s bond-buying program. See ‘German court hears case against ECB bond-buying.’  30 July 2019. ft.com/content/c19132ec-b2b3-11e9-bec9-fdcab53d6959

[9] Independent. ‘Brexit: Mark Carney defends Bank of England over ‘Project Hysteria’ claims after EU exit forecast published.’ 29 November 2019. independent.co.uk/news/uk/politics/bank-england-brexit-mark-carney-economic-forecast-project-hysteria-jacob-rees-mogg-a8657566.html

[10] Witness the destruction of the reputation of Alan Greenspan,  the second-longest-serving Fed chief, who served four president from 1987 to 2006 as he presided over a period of steady growth and low inflation known as the ‘Great Moderation’ credited in no small way to an ‘independent’ Fed focused on price stability. See Federal Reserve history. ‘The Great Moderation.’ federalreservehistory.org/essays/great_moderation?WT.si_n=Search&WT.si_x=3.

[11] BOE Governor Mark Carney is leading a coalition of 30 central banks calling for action on climate change. See Bank of England. ‘Climate change.’ Fed Chairman Jerome Powell has said the Fed is preparing the financial system for “severe weather events” See letter Powell to US Senator Brian Schatz dated 18 April 2019. documentcloud.org/documents/5992917-Chair-Powell-to-Sen-Schatz-4-18-19.html

[12] A Canadian senator in 2018 criticised Bank of Canada Governor Stephen Poloz for supporting the government’s workforce gender quotas. See Financial Post. ‘Central bankers can’t be expected to stay silent in a post-crisis era.’ 27 April 2018. business.financialpost.com/news/economy/central-bankers-cant-be-expected-to-stay-silent-in-a-post-crisis-era

[13] Many argue the decline in bank net interest margins hampers lending. See Markus Brunnermeier and Yann Koby of Princeton University. ‘The ‘reversal interest rate’: An effective lower bound on monetary policy.’ 10 July 2019. scholar.princeton.edu/sites/default/files/markus/files/17e_reversalrate.pdf

[14] This practice was known as printing money and now is often called helicopter money after Milton Friedman used the term. Quantitative easing is different in that central banks are buying bonds in the secondary market, usually from their primary banks. Quantitative easing does not fund government deficits, thus crossing into fiscal policy.

[15] An IMF study on why inflation has failed to shift much since 2008 concludes that the victory of central-bank independence is that it has cemented low-inflation expectations in the mind of the public. “As long as inflation expectations remain firmly anchored, fears about high inflation should not prevent monetary authorities from pursuing highly accommodative monetary policy,” it says. “In this regard, preserving central banks’ independence is key.” IMF. World Economic Outlook. April 2013. Chapter 3. ‘The dog that didn’t bark: has inflation been muzzled or was it just sleeping?’ Pages 1 and 14.

[16] See Sarah Binder and Mark Spindel. ‘The myth of independence. How Congress governs the Federal Reserve.’ Princeton University Press. 2017. press.princeton.edu/titles/11123.html. See Bloomberg article by the same authors. ‘How Congress governs the Fed.’ 28 September 2017. bloomberg.com/opinion/articles/2017-09-27/how-congress-governs-the-federal-reserve

[17] See Ashoka Mody. ‘EuroTragedy’. Oxford University Press 2018. Pages 10-11, 160-161 and 503. Note too that the European Parliament was given no authority over the central bank even though the ECB president reports to the body.

[18] See Council on Foreign Relations. ‘Germany’s central bank and the eurozone.’ 6 February 2013. cfr.org/backgrounder/germanys-central-bank-and-eurozone

[19] Federal Reserve history. ‘Treasury-Fed accord.’ federalreservehistory.org/essays/treasury_fed_accord

[20] Federal Reserve history. ‘Federal Reserve Reform Act of 1977.’ federalreservehistory.org/essays/fed_reform_act_of_1977?WT.si_n=Search&WT.si_x=3

[21] Reserve Bank Governor Bernie Fraser. Speech to the National Press Club, Canberra 15 August 1996. ‘Reserve Bank independence.’ Reprinted in the Reserve Bank of Australia Bulletin. September 1996. rba.gov.au/publications/bulletin/1996/sep/pdf/bu-0996-4.pdf

[22] Some question if a 2%-inflation goal is the right target for central banks. One study suggests the US economy would have recovered faster if the Fed had a higher target and could have cut rates more aggressively. See Janice Eberly, James Stock and Jonathan Wright. ‘The Federal Reserve’s currency framework for monetary policy: A review and assessment.’ NBER Working Paper No. 26002. June 2019. nber.org/papers/w26002

[23] Andrew Haldane, chief economist, Bank of England. Speech. ‘Climbing the jobs ladder.’ 23 July 2019. Page 31. bankofengland.co.uk/-/media/boe/files/speech/2019/climbing-the-jobs-ladder-speech-by-andy-haldane.pdf?la=en&hash=427F17CEDFEC6AE82075792F82238C96006F65BC

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