In defence of central bank independence

Are the markets reliant on central banks for support? Yes. This is a function of two variables. First, new entrants in to the markets over the last decade or so have come to rely on monetary policy at the first sign of trouble. Secondly, there is a belief that the monetary side of the policy mix is the only game in town.

The asymmetric reaction to the final sales line of US GDP over Q1/Q2 serves as a reminder that the US economy is in good shape, but that markets seem intent on driving the US Federal Reserve to ease. Q1 final sales slowed sharply and the market priced for much easier policy. Q2’s was strong and the market continued pricing easier policy.

In the days of yore, such a data outturn would probably have been enough to prevent a rate cut at the July FOMC. Still, the second point is reinforcing the first, especially in Europe. Markets (globally) are telling governments that central banks cannot do it all alone and yet at the same time are showing no belief that fiscal policy will be enacted to support economies.

Even the proposed new ECB chief, Christine Lagarde, who it is suggested will be able to use her political skills to arm twist EMU fiscal gatekeepers into submission, has failed to convince the markets that she will do the trick Mr Draghi, despite his overt calling, has failed to.

There is always some political influence

It is, therefore, ironic that some politicians who are causing the uncertainties that are impeding economic growth, are also those shouting loudest in what is being interpreted as an attack on central bank independence.

There is always some political influence over central banks in that policy committee candidates go through a nomination and confirmation process which is run by politicians and recall, there wasn’t much political goodwill towards Mervyn King in his latter days as Bank of England Governor which clearly impacted then Chancellor George Osborne’s decision to replace King with Mark Carney. President Trump is making a great deal of noise about the Fed ‘letting us down’ for not doing as he wants (when did a real estate person want anything but low rates anyway).

Whereas the selection process is politically influenced, the decision and policy making process is generally accepted to be independent; although we can see clearly see one avenue President Donald Trump is attempting to influence the Fed’s decision making process by nominating FOMC candidates who follow his beliefs i.e. those who would pursue an aggressive expansionary policy by enacting a large interest rate cut immediately and possibly reverse quantitative tightening.

The standard argument in favour of independence is that politicians tend to manipulate policy to suit the election rather than business cycle (I wonder, has President Trump shot the fiscal bolt with the tax cuts?  It seems he wants the Fed ease to offset the trade tensions).  There is the example of then UK Chancellor Nigel Lawson during the 1980s – and remember the BoE was granted independence in 1996.

Lawson pursued an expansionary fiscal and monetary policy which caused economic growth to far outstrip the economy’s trend growth rate, then at 2.5%. However, all this did was fuel inflation and interest rates were jacked up sharply to take the heat out of the economy resulting in a recession and the classic ‘boom-bust’.

Since the financial crisis, monetary policy has become far more complex and there are many policy channels than there used to be, so it might also be that politicians do not necessarily understand the intricacies of monetary policy. And what would a politician do with Quantitative Easing (QE)?  History does not suggest ‘act wisely.’ 

Governments have a history of creating boom-bust conditions which causes inflation expectations to rise which in turn makes higher inflation levels more likely. It is arguable that an independent central bank with an inflation mandate supports more stable macro policy versus the alternative of politicians with their hands on the levers and therefore allows for economic agents to plan with greater certainty.

Where are some of the current macro-shocks emanating from? Trade tensions and Brexit are both politically motivated. Yes, the system took its collective eye off the ball in the lead-up to the Financial Crisis, Great Recession and Euro Crises, but would politician run central banks have done any better? And don’t forget, if the seed was a crisis of regulation, then the politicians are also to blame for this.

Perhaps there are those on the political side that want extremely loose financial conditions to fuel another leg to the stock market rally which runs the risk of causing an asset price bubble and threaten to financial stability. This is another example, alongside price stability, where the objectives of independent central bankers and politicians are unlikely to align. The same can be said targeting FX levels and not all jurisdictions can have a weaker currency.

Threats to central bank independence

How independent are central banks though? Nobody in their right mind doubts that monetary policymakers could do little else but aggressively ease in the aftermath of the various crises mentioned above. At the time, there are few who thought the global economy would still be so fragile that another heavy dose of the same medicine would be required when so much of it is yet to be taken back.

However, in unintentionally supporting the explosion of debt, some central banks have unwittingly via QE become effective lenders of last resort to governments. Low rates prevent large swathes of economic agents from going bust, but the combination with QE is suppressing yield curves that could be considered supportive of government finances where in the past market discipline would have forced a different outcome. 

In the EMU, the distortions leave Italian and Greek 10-year yields below that of the US. In theory, this makes Italy and Greece less risky than the US!  It is here where a central bank runs the risk of being accused of being an arm of fiscal policy. 

Further, does this allow for proper checks and balances by elected officials, politicians, of unelected officials – the central bankers?  By this I wonder if a politician from a country that is clearly benefitting from having the cost of its capital suppressed is going to rigorously perform checks and balances of the institute that is performing the benefit! Any future ECB asset purchases run the risk of falling foul of both the latter two accusations.

For now I do not think there is enough support in advanced economies for central bank independence to be taken away, even in the US. There is research to suggest that the higher the degree of independence, the better the inflation performance. This may sound ironic given current struggles in several jurisdictions to force inflation back to target, but ‘lowflation’ is better than the high and hyperinflation.

The damage too high an inflation rate can do to an economy is a reason enough to keep those with a record of creating the economic conditions for this to happen away from the monetary policy levers.  And it seems central banks themselves have learnt to operate with discretion, even when inflation targets have been breached. Then BoE Governor King came in for some heavy criticism not so long ago for letting inflation get to the ‘problematic’ level of just over 5% y/y (try telling folks who remember the 70s that this is problematic!).

King, correctly as it turns out, laid the blame on global commodity prices which would work itself out.  The ECB has been accused of sticking too rigidly to its mandate with some ill-judged rate hikes. ECB President Draghi has shaken off most this mantra. It is within QE and the low rates culture that I wonder if the seeds of a populist form of anti-Central Bank independence might grow.

By this I mean a perceived impact of QE and negative interest rates that have had the side effect of promoting financial inequality. All policy has distributional effects, but low rates and QE have benefitted the owners of capital rather than the labour force in terms in of wealth accumulation. A counterfactual argument is that if it hadn’t been for easier monetary policy, the impact of the various crises would have been much worse. But this argument will only wash for so long and if politicians get the whiff of an electoral victory based on fighting the distributional effects of monetary policy, then there is a chance they will curtail central bank independence.

Further, if the current economic and financial market dynamics continue, politicians may come under more political pressure ‘to do something’ to offset negative carry/returns that easy monetary policy is promoting. The asset management industry is going to come under a great deal of pressure to generate returns in an environment where there is an increasing amount of sovereign debt with negative yields. 

Asset managers are therefore faced with buying negative yielding debt, and there is a shortage of what is termed ‘safe’ sovereign debt in the Euro Area, or they must purchase more risky assets such as equities, Emerging Market debt/equities and go down the liquidity spectrum.  Just the sort of stuff they should be moving out of when/if the global economy heads into a downturn.  It is still some way off, but if asset managers fail to match liabilities with returns, will this result in, for instance, a need for pension benefits to be cut?  

Who would you rather have on the tiller in such circumstances?

Marcus Dewsnap is Head of Fixed Income Strategy at Informa Global Markets.

More from Marcus Dewsnap:

• Monetary policymakers’ non-financial corporate debt conundrum, 1 Apr 2019
• The US economic growth engine that might impact the ECB, 5 Oct, 2018
• 10-years on from Lehman collapse and still relatively easy money in Europe, 11 Sept, 2018