9 November 2017

The beginning of the end

Politics is impinging on central bank independence.

by Frank O’Nomics

“So Mr Powell, you have had no formal training as an economist and have had less than 5 years experience working within a central bank.  Well, that all seems in order – how would you like the most important role in the global economy?”  It seems somewhat strange that, despite his inexperience, and being the first Governor of the US Federal Reserve in forty years not to be an economist, Jay Powell has been given the job.  There has been no suggestion that he is anything other than a safe pair of hands, and most commentators talk of the maintenance of continuity, but the move does seem to be politically motivated.  The current incumbent, Janet Yellen, is widely regarded as doing a very good job, yet this is the first time since 1935 that a chairman has been denied a second term when they were prepared to serve.  Donald Trump has said that as a president, “you’d like to make your own mark”.  That might be so, but we should not lose sight of the fact that Ms Yellen is a Democrat and Mr Powell is a Republican.

You could argue that the Fed’s mandate is very clear and does not allow political interference, but there are a great many vacancies on the Federal Reserve Board (previous members seemingly not wanting to stick around) and politics could play a part in their selection also.  The problem is that politicians are happy with independent central banks until they start to behave in ways counter to their policy objectives.  With rates starting to rise that point could become much closer, and the questioning of central bank mandates is beginning in several countries already.

Take for example what used to be the role model for the UK approach, New Zealand.  Here too there are signs that politics is starting to playing its part, with the new Finance Minister suggesting that RBNZ could have an employment target added to its inflation mandate.  The new prime minister has set a target of getting unemployment below 4%, but if rates were to rise next year (as the market expects) this may be harder to achieve.  Adding an employment target to the RBNZ mandate may actually mean a further cut in interest rates from a current record low of 1.75%.

Closer to home, the Bank of England recently celebrated 20 years of independence and, in line with the target of keeping inflation below 2%, last week increased interest rates for the first time in 10 years.  Many would argue that, given the low levels of growth (forecasts were reduced last week) and significant uncertainty, they have moved in the wrong direction.  Even within the circles that granted the Bank control over interest rates there are suggestions that it has too much power, with the government having delegated total control over ensuring financial stability.  Ed Balls has argued for more political control of the Bank, with the Chancellor of the Exchequer taking responsibility for financial stability.  Gordon Brown has said that it will be difficult to deal with any future financial crisis if the Bank and the government are not working together.  He has been critical of the Bank for asking him not to use fiscal policy to combat the downturn resulting from the financial crisis, whilst being slow to  cut rates so that he had little alternative.

Taking the role of ensuring financial stability back within government may not impinge on the independent setting of interest rates, but it may well be the start of such a process.  Lord Robert Skidelsky, Emeritus Professor of Political Economy at the University of Warwick has argued that there is a need for an overall economic strategy in which monetary and fiscal policies combine.  The current system means that these policies are separately set, and often run counter to each other.  Central bank independence is cited as being the key factor behind keeping inflation low for so long, but you could argue that this was just luck – occurring as it did at a time of the opening up of China and much lower energy prices.  Critics would argue that central banks were singularly unsuccessful in spotting the financial crisis and have failed (other than in the UK where Brexit has played its part) to get inflation back to its target.  The next economic downturn could be the prompt for rethinking central bank independence, with the Treasury taking back some element of control over the setting of interest rates.

There is an alternative to taking some responsibility for monetary policy back within the government, which is to make central banks even more technocratic.  If interest rates were to be determined by a very strict and rigorous set of criteria, with data constantly being fed into a model that generates the desired level of rates, the process could become automatic, with minor changes taking place on a very regular basis.  The apparent failure of the Bank of England’s policy of forward guidance would suggest that this would be a good way of eradicating interest rate uncertainty.  However, making interest rates dependent on an algorithm takes away the opportunity to be preemptive and proactive.  Just because the MPC has not necessarily demonstrated these qualities so far, doesn’t mean that it is not a good idea to give it the scope to do so.

We should not confuse independence with omnipotence, and both the Fed and the MPC can only be successful in using interest rates to help to deliver prosperity if other policies are in harmony.  Developments in the US and elsewhere suggest that central bank independence is under threat.  The setting of central bank mandates will always have some political element, but if the process means that monetary and fiscal policies become more “joined up”, this does not have to be a bad thing.

 

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