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Era of independent central banks is over
10 Jan 2013
Stephen King, Group Chief Economist
Whether they like it or not, central bankers are being dragged into the political fray. It is not so much an issue of whether independence is good or bad. Rather, monetary policy itself is no longer a job for technocrats.
Pre-crisis, it was assumed the achievement of price stability would keep everybody happy. Yes, central bankers would have to nudge interest rates in one direction or the other, making some of us better off and others worse off. Across an economic cycle, however, these effects would even out. In that sense, monetary policy could be regarded as politically neutral.
No longer. Since the recession, developed world economies have stagnated and central bankers have had little choice but to keep rates close to zero and to pursue increasingly unconventional monetary policies in the hope that they will trigger a robust recovery.
Monetary policy today carries big political connotations. In the UK, for example, the most obvious sign is the Bank of England's willingness to tolerate a rate of inflation far above the target set by parliament. While there is a reasonable justification – far better, surely, to squeeze all workers' wages in real terms than to have a Depression-style rise in unemployment – it is not at all obvious that it is a decision to be made by the high priests of the central banking community alone.
There are less obvious effects that also warrant greater scrutiny. Quantitative easing may make it easier for governments to raise funds cheaply; but, by increasing the net present value of pension funds' future liabilities, it creates problems for those funds already running deficits. That, in turn, means either bigger pension contributions for workers; lower prospective pension benefits; or, in the case of some public sector pensions, tax increases or spending cuts to make the numbers add up. Meanwhile, some of the biggest beneficiaries of QE are those already asset-rich and relatively old who prefer to sit on their windfall gains rather than spend them.
Central bankers are making decisions that are more political than economic.
Put another way, monetary policy is doing more to redistribute income and wealth than to trigger a rebound in economic activity. Central bankers are making decisions that are more political than economic.
So it should come as no surprise that central bank independence is under threat. Nowhere is this more obvious than in Japan, where Shinzo Abe's new government is planning both to appoint a new Bank of Japan governor and to refine the bank's price stability mandate. The BoJ is likely to find itself under pressure to hit an inflation rate of 2 per cent rather than the current 1 per cent objective, bringing it into line with central banks elsewhere.
It seems a reasonable ambition. But announcing an ambition does not necessarily imply it will be met. Supporters of struggling Aston Villa, for example, surely hope their team will one day win the English Premier League. On current form, however, the chances seem remote. Likewise, even if the BoJ hoped to hit a 2 per cent target, would it have the tools to do so?
Imagine it does not. The obvious thing would be to send for the monetary helicopters, namely a big increase in the budget deficit to be funded through sales of newly issued government bonds to the central bank. At that point, the bank's politicisation would be more or less complete: it would be no more than an agency of government.
We cannot know how the Japanese public would behave under those circumstances. Would they view a helicopter drop as a logical extension of unconventional policies, leading to a modest rise in inflation? Or would they take the view that the BoJ was now a passive agent of fiscal policy, no longer able to offer monetary discipline? If so, it surely would not be long before they dumped their yen, triggering a shift from excessively low to excessively high inflation.
I know it is hard to imagine, particularly in a country dogged by deflation. But following two decades of central bank independence, we have to face facts. They can no longer be properly "independent" because their policies are creating both winners and losers. They are making decisions that are inherently political. Once politicians recognise this they will surely be tempted to take over the reins. At that point, monetary stability, for good or bad, can no longer be guaranteed.
Stephen King originally wrote this article for the Financial Times newspaper, published on 10 January 2013.