BY MEGAN WHITE
Of the many possible sites for a heated political showdown, the target federal funds rate hardly registers on the front lines. Yet in December 2018, US President Donald Trump took to Twitter to decry the US Federal Reserve’s decision to raise its benchmark rate. Breaking more than two decades of White House silence on monetary policy, Trump declared, “The only problem our economy has is the Fed,” and reportedly threatened to fire Chairman Jerome Powell.
Trump’s comments come at a time when central-bank independence is being challenged across the globe. Since the 1970s, the prevailing consensus in the monetary policy making community has been that central banks are best positioned to pursue price stability when they are free from day-to-day political pressures. Central banks, which oversee the supply of money in a country’s economy, are typically charged with maintaining price stability and serving as a lender of last resort. They do this through monetary policy, which can involve buying and selling government bonds, setting overnight interbank interest rates, and adjusting reserve requirements. Monetary policy has generally been kept separate from the rough-and-tumble world of fiscal policy making in both developed and emerging markets. Insulating central banks from electoral politics fosters a long-term perspective and credibility in monetary policy, both of which are important for limiting economic volatility. If central bankers are not operationally independent, they may face short-term pressure to overstimulate the economy beyond its underlying potential, creating inflationary pressure. Investors, employers, and consumers would not necessarily trust their central banks to pursue low inflation and market stability—a dangerous loss of trust in a world where market jitters can so often become self-fulfilling prophecies.
The operational independence of central banks is thus an ideal worth maintaining. But in a world beset by slowing productivity, unequal growth, and mounting waves of authoritarian populism, the electoral insulation around monetary policy risks being washed away.
The Winter of Our Discontent
Donald Trump’s attacks on the Federal Reserve fall against a backdrop of increasing global discontent with independent and seemingly unaccountable central banks. According to a 2018 Gallup poll, the share of Americans expressing confidence in the Federal Reserve’s ability to shepherd the economy declined from nearly 80 percent in 2001 to just above 40 percent in 2018, leading to calls and even legislation to “audit the Fed.” Similarly, a 2017 Eurobarometer poll found that the percentage of Europeans who “tend not to trust” the European Central Bank jumped from 25 percent in 1999 to 45 percent in 2017. Governments of numerous countries—including financial centers such as Japan, India, South Africa, and Nigeria—have taken steps to increase political control over their central banks’ regulatory and monetary powers, from subjecting central-bank policies to committee review to issuing direct policy instructions.
Popular skepticism over central banks’ role in the economy is not unfounded. Since the 2008–2009 global financial crisis, the purview and powers of central banks have expanded significantly. Once focused almost solely on managing inflation, central banks around the world are now tasked with broader financial stability, a more nebulous mandate that cannot be easily defined or measured. This extended mandate has also placed central banks in the position of choosing the right trade-off between stability (e.g., through more conservative policy regarding borrowing and lending) and economic dynamism, an inherently political decision.
But while political decisions warrant political accountability, it is important to separate central banks’ financial-stability functions from their core monetary functions. Political decisions with direct distributional consequences, such as whether or not to rescue specific financial institutions or where to set loan-to-value ratios, demand transparency for the sake of holding policy makers accountable. Moves to encroach on the independence of central banks’ ability to set target interest rates, however, pose risks for the long-term stability of the global economy. If core monetary decisions are at the mercy of election cycles, then central banks will face pressure to pursue unsustainable rates of growth, opening the door to dramatic boom/bust cycles.
The Evolving Role of Central Banks
Traditionally, central banks have primarily been responsible for stabilizing the business cycle. This task has generally involved defining an explicit inflation target and varying interest rates in pursuit of that target. The principle that decision-making around monetary policy should be shielded from political pressures was enshrined in the late 1970s, when then-US Federal Reserve Chairman Paul Volcker took drastic measures to curb high inflation. Volcker’s efforts drew sharp criticism at the time, and many credit the “Volcker Shock” with causing the 1981–1982 recession. But despite the short-term pain they caused, Volcker’s policies ultimately brought inflation to heel and implied that the markets could trust an independent central bank to do what’s right for the economy in the long-term.
Since the Volcker era, policy makers and academics alike have largely championed the operational independence of central banks. At least 30 countries enshrined central-bank independence in legislation between 1990 and 1995. The 1992 Maastricht Treaty, which established the European Union, explicitly describes the value of central-bank independence and a commitment to low inflation levels. A series of papers in the 1980s and 1990s identified a strong negative correlation between countries’ inflation levels and their degree of central-bank independence and further found that the inflation benefits of independence came at no cost in terms of real macroeconomic performance. The papers’ general hypothesis is that delegating monetary policy to an independent body avoids the problem of voters rejecting any policy they view as too conservative on inflation and thus permits a lower rate of inflation than may otherwise be possible.
This understanding of the relationship between central-bank independence and control over inflation was reflected in the core mandates of many central banks. Though specifics varied by country, central banks’ mandates before the 2008–2009 global financial crisis generally involved two components: a focus on meeting a price-stability objective and a responsibility for providing liquidity re-insurance to the financial system as the lender of last resort (i.e., bailing out troubled institutions). The supervision and regulation of financial institutions typically took place outside of the central bank (e.g., the UK’s Financial Services Authority) and at a micro-prudential (i.e., individual as opposed to systemic) level. In the event of a systemic crisis, central banks’ lender-of-last-resort function was expected to be sufficient to stop the crisis from spreading.
Central Banking after the Crisis
The financial crisis significantly altered the landscape for central banks and raised questions about their ability to make the right decisions for the economy, ultimately giving way to questions about the value of their independence. The crisis and its immediate aftermath revealed the shortcomings of the traditional model, including a failure to maintain financial stability, a failure to restore stability in transparent ways, and the inadequacy of central banks’ core toolkits in the face of persistently low inflation.
In response, many governments expanded the powers of their central banks into the realm of financial stability. These new powers require some banks to wade into politically contentious areas, such as housing policy, and to use more unconventional tools, such as quantitative easing and loan-to-value ceilings, which have direct fiscal and distributional implications. Loan-to-value ceilings, for example, affect the cost of taking out a mortgage and therefore impact the housing market. The idea of unelected economists having the power to set such policies has raised eyebrows across the political spectrum, from Marco Rubio to Bernie Sanders in the United States and William Hague to Jeremy Corbyn in the United Kingdom. As banks enter the political arena, all aspects of their mandates, not simply those that are inherently political, have come under scrutiny.
This increased scrutiny has manifested in various forms. In the United States, Senator Rand Paul’s (R-KY) 2015 “Audit the Fed” legislation aimed to require the Federal Reserve to set interest rates according to a predefined rule. In India, the Modi administration has put intense pressure on the Reserve Bank of India (RBI) to pay more of its annual surplus to the government and to reduce its lending curbs, which could help ease a recent liquidity squeeze in the debt market (these demands culminated in the abrupt resignation of RBI Governor Urjit Patel in December 2018). A 2016 survey of 200 central-bank heads and academics found that over one-third of academics and 10 percent of central bankers thought that independence was either moderately or greatly threatened.
The sentiment fueling this backlash against central-bank independence is the same sentiment fueling popular distrust in government institutions worldwide and rests on a perception that central banks primarily serve the interests of the elite. The spirit of Donald Trump’s calls to “drain the swamp” in Washington is reflected in the rise of populist and nationalist parties across Europe and Asia. In this light, the idea of a group of highly educated, unelected officials making decisions impacting the broader public is understandably unsavory. Near-zero interest rates following the financial crisis mean that central banks’ traditional tool for stimulating the economy, lowering target rates, is of limited effectiveness. Expanding toolkits have led central banks to become increasingly entwined in securities markets, extending their power into the fiscal, and therefore political, realm. Greater transparency in monetary decision-making and coordination with elected officials over fiscal policy is possible—even necessary—for effective policy making. But allowing full political control over banks’ core monetary functions could prove economically disastrous.
The Politicization of Central Banks in Practice
The recent Turkish lira crisis illustrates the danger of politicizing interest rates. In August 2018, the Turkish lira had lost over 50 percent of its value against the US dollar. The devaluation was fueled in part by investors’ fear that Turkey’s economy was overheating and that its loose monetary policy could not contain runaway inflation. Turkey previously financed a wave of rapid growth with short-term portfolio flows in stocks and bonds from abroad, but low interest rates meant that capital could not stay in the country. Maintaining low interest rates despite double-digit inflation and the collapse of the lira was an explicit policy of President Recep Tayyip Erdogan, who applied intense pressure on the central bank out of a desire to fuel economic growth ahead of June elections. Though the bank eventually defied Erdogan’s orders and raised rates in September 2018, stemming the lira’s slide, Erdogan continues to describe interest rates as “an instrument for exploitation” and has claimed the exclusive power to appoint central bankers. Despite the rate hike, Turkey is still facing the consequences of Edrogan’s entry into monetary policy: multiple ratings agencies, including Fitch and Moody’s, have downgraded 20 Turkish banks, citing the lira’s slide as a key factor in their decisions. A credit downgrade means that it will be more difficult for the banks to obtain loans on the money market and also signals to potential creditors that the banks are less stable. In a global market heavily fueled by expectations, the idea that a central bank cannot credibly fulfill its mandate is alone enough to spook investors.
Trump’s calls for the Federal Reserve to maintain low interest rates in the United States are rooted in a similar desire to boost short-term economic growth. But such growth is not sustainable, and indefinitely maintaining low rates takes an important monetary policy tool off the table. As former Federal Reserve Chairman William McChesney Martin stated in 1955, the central bank’s job is not to be popular in the near term but “to take away the punchbowl just as the party gets going.” If central bankers serve at the pleasure of election cycles, they will not be able to make hard decisions required for economic stability, and their commitments will not be credible. Dismissing Jerome Powell over an interest-rate hike would send the message to future central bankers that their jobs depend on pursuing growth at any cost and would lower market confidence in the institution. Indeed, Trump’s Christmas Eve tweet citing the Fed as public enemy number one contributed to a 653-point (2.9 percent) decline in the Dow Jones Industrial Average.
Central-bank independence is intended to protect currencies from politics by preventing politically engineered business cycles and mitigating any pressure to finance deficits. When monetary policy is politically motivated, or when bank chiefs risk being fired for raising rates, policy makers cannot and will not take measures that may be necessary for long-term economic stability. As the role of central banks shifts, popular discontent and calls for greater operational transparency are not unwarranted. Institutions cannot operate in a vacuum. Transparency, however, does not require eliminating banks’ independence.
Megan White is a graduate of the John F. Kennedy School of Government at Harvard University. Prior, she worked as a business analyst at McKinsey & Company, where she worked primarily in the organization’s private-equity practice. She is a graduate of the University of Georgia with degrees in economics and international affairs.
Edited by: Jaylia Yan
Photo by: Wikimedia Commons
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