The Chief Economist’s Note

In defence of central banks

Populist governments have already challenged several areas of received economic wisdom, so it was perhaps only a matter of time before they turned their focus to central banks. As ever, President Trump has grabbed most of the headlines by griping at the Fed for tightening policy. But Italy has put pressure on the ECB to extend its programme of asset purchases. And several central banks in the emerging world – notably in India and Turkey – have also felt the wrath of government at various points over the past few years.

All of this raises the question – how seriously should we take the threat to independent central banking?

As it happens, the concept of a central bank that is independent from government is not particularly new. The Bundesbank has been independent since its inception shortly after World War Two. And the Fed has been independent since the 1950s. Instead, the key development over the past 25 years or so has been that independent central banks have operated within a regime of inflation targeting – initially in the form of a desired range for inflation and, more recently, in the form of explicit targets.

This did two things. First, the target sent a clear signal to households and businesses about the desired rate of inflation. And second, the separation of the central bank from government took responsibility for delivering that rate of inflation out of the hands of politicians.

The former was important because it anchored expectations, thus preventing wages and prices from being bid up (or down) in anticipation of higher (or lower) inflation rates in the future. The latter was important because it gave credibility to the policy framework. By removing monetary policy from the day-to-day control of government, it prevented it from being set for political ends.

There is a legitimate argument that targets focussed on consumer price inflation were too narrow in their construct, since they failed to take account for broader shifts in asset prices and the associated risks to financial stability. But regardless of the merits of this argument (and I happen to find it persuasive) it remains the case that, when viewed against the narrow objective of anchoring consumer price inflation, inflation targeting by independent central banks has been a success.

In the 1980s and early 1990s when excessive inflation was the dominant global concern, inflation (and inflation expectations) were brought under control. Similarly, an equally damaging period of deflation was averted in developed markets in the aftermath of the global financial crisis.

So what should we make of the recent challenges to central bank independence? The first point to note is that, in the case of the US, this spat may simply blow over. Trump’s fiery rhetoric has not been accompanied by substantive actions and, as we’ve noted on our US service, it’s not clear that he can legally remove Fed Chair Powell or that doing so would change the conduct of policy in practice.

Moreover, for developed markets, very low inflation (or deflation), rather than excessive inflation, is likely to pose the biggest threat over the next decade. If so, there is less reason to worry about populist governments leaning on central banks to keep policy loose.

However, this is not true of all emerging economies. Turkey’s recent troubles illustrate how government pressure to keep interest rates artificially low can lead to inflation and balance of payment problems. Viewed this way, recent developments in India look ominous.

Meanwhile, although inflation may not pose a major challenge to developed economies over the coming years, there are still ways in which government pressure to keep policy loose could create problems. In particular, moves to roll back regulatory changes made in the wake of the global financial crisis, or to loosen the credit spigots more generally, could inadvertently sow the seeds of the next crisis.

Stepping back, one unintended consequence of the large volumes of asset purchases made by developed market central banks over the past decade has been to blur the lines between monetary and fiscal policy. Optimists might argue that this could create the conditions for closer policy co-ordination and a more rational debate about how central banks (and governments) can best achieve multiple objectives of fostering growth, anchoring inflation and maintaining financial stability. This may yet happen. But the evidence so far makes it look like wishful thinking. With the global economy likely to slow over the coming quarters, it seems more likely that central banks will continue to come under fire from populist leaders.

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