Central banks risk seeing their feted 'independence' watered down

The views and opinions expressed in this article are those of Magellan Asset Management Limited (Magellan) and may not reflect the views of BT (part of the Westpac Banking Corporation) or other companies in the Westpac Group.

Michael Collins, Investment Specialist, Magellan

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 street. The president from 1945 to 1953 stared at Martin, called him a “traitor” and walked away. 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.

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.’” 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” “enemy” Jerome Powell about 50 times since mid-2018. 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.

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. 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 and gender quotas. 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 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 Shinzō 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.

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. 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’. Central banks are entwined in politics because they form part of the executive and they often cooperate with Treasuries. 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.

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.