Centre stage: political disputes have thrown central bank policy into the limelight

The role of central banks as neutral stewards of the financial system is being undermined by a mix of populism and economic structural changes

Centre stage: political disputes have thrown central bank policy into the limelight
US President Donald Trump’s remarks about Fed Chair Jerome Powell in October 2019 opened a new chapter in the history of the relationship between politicians and central bankers 

“China is not our problem, the Federal Reserve is,” Donald Trump tweeted in October 2019, in one of his usual tirades in the small hours of the night. It was not the first time the US president had vented his anger at Jerome Powell, Chairman of the Fed, whom he appointed last February, but this time the message was clearer: “People are VERY disappointed in… Powell and the Federal Reserve. The Fed has called it wrong from the beginning, too fast, too slow.”

Although the US central bank had already cut interest rates three consecutive times, this was not enough, according to Trump: “We should have lower interest rates than Germany, Japan and all others. We are now, by far, the biggest and strongest country, but the Fed puts us at a competitive disadvantage.”

Criticism of central banks is not unprecedented in the history of the US: Richard Nixon famously pressured Arthur Burns, the Fed chairman at the time, to loosen up monetary policy in the run-up to the 1972 election. Ronald Reagan was equally harsh towards Paul Volcker. However, Trump’s remarks open a new chapter in the history of the relationship between politicians and central bankers, the latter traditionally seen as non-political figures who – out of virtue or necessity – stay out of the diplomatic fray.

“Trump has no intellectual or personal issues with Powell – he just finds him to be a convenient target,” said Professor Paul Wachtel, an expert on central banking who teaches at the New York University Stern School of Business. But, he added, Trump’s tantrums reflect a broader trend: “Powell has no political base of his own and bankers are a frequent target for anti-Semites and others; Trump is trading on the world’s hatreds.”

Autonomous no more
An independent central bank has not always been an axiom of global finance. The rise of monetarism in the 1980s convinced politicians that thankless tasks such as setting interest rates would be better off left to technocrats. Depoliticising monetary policy was deemed the key to unshackling central banks from the whims of public opinion and party politics; their governing boards were left alone to achieve price stability. In the UK, it was Tony Blair’s Labour government that granted independence to the Bank of England in 1997, while the European Central Bank (ECB) has been independent from the outset, with low inflation stated as a key target in its charter.

Slowly but surely, independence became the global norm, even in parts of the world where other institutions are particularly weak. A 2008 working paper from the IMF showed that the idea had been in the ascendant in emerging market economies since the 1980s, while international organisations such as the World Bank and the IMF often include central bank independence as a prerequisite to participating in loan and aid programmes. Even the People’s Bank of China, which is accountable to the State Council and the country’s ruling Communist Party, has occasionally resisted government pressure.

However, the needle seems to have moved over the past few years. In various parts of the world, the privilege of central banks to set monetary policy unperturbed by external forces is increasingly coming under fire. In July 2019, Turkish President Recep Tayyip Erdoğan abruptly sacked the governor of the country’s central bank, Murat Çetinkaya. The reason, Reuters reported, was that Çetinkaya had refused to succumb to pressure for an interest rate cut – a move that would be in line with Erdoğan’s unorthodox view that high interest rates drive up inflation.

Depoliticising monetary policy was once deemed the key to unshackling central banks from the whims of public opinion and party politics

In India, meanwhile, Governor of the Reserve Bank of India Urjit Patel cited personal reasons for resigning in December 2018, but many at the bank suggest he was forced to leave after a series of clashes with the government which pressured the bank to use its surplus to plug budget gaps, increase spending before a general election and loosen up lending to tackle a shadow banking crisis.

Overstated powers
Central banks in advanced economies have not escaped this trend. In the UK, pro-Brexit politicians rebuked the Bank of England’s forecast that a no-deal Brexit would lead to recession and the collapse of the pound, referring to it as part of an anti-Brexit smear campaign known as ‘project fear’. The Canadian governor of the bank, Mark Carney, has become a bête noire for the Tory party’s pro-Brexit faction; the MP and prominent Brexiteer Jacob Rees-Mogg has called Carney the “high priest of project fear”.

Even that pales in comparison with the salvo of insults regularly unleashed by the US president, who never misses an opportunity to fulminate against the Fed and its chairman. In October, Trump said that he’s “not even a little bit happy” about Powell’s performance – he also hinted that he may nominate economic advisor Stephen Moore and former Republican presidential candidate Herman Cain to the bank’s board. Francesco Bianchi, an associate professor of economics at Duke University, told World Finance that one explanation could be that Trump “needs the backing of the monetary authority in light of his trade war [with China] and to confirm the narrative that the economy is doing very well”.

But public criticism of the Fed does not come without consequences: in a recent paper, Bianchi, along with London Business School academics Howard Kung and Thilo Kind, provided market-based evidence that Trump’s tweets have a direct impact on expectations about monetary policy: “Market participants believe that the Fed will succumb to the political pressure, which poses a significant threat to central bank independence.” Nor is this type of criticism a privilege of America’s conservatives: Bernie Sanders, a leading figure of the Democratic Party’s left wing, has often argued that the Fed is in bed with Wall Street interests.

One reason why politicians don’t hesitate to criticise central banks is the shattered reputation of the financial sector after the Great Recession. Paul Tucker, former deputy governor of the Bank of England and author of a book on the role of central banks in modern democracies, told World Finance: “Being the ‘only game in town’ in [an effort] to stave off complete collapse and then revive the economy has, perversely, made central banks part of the political game. And avoiding complete collapse did not cure concerns about inequality or persistently weak growth.”

Some take this argument one step further, claiming that central banks should be governed as any other political institution. In his book The Power and Independence of the Federal Reserve, Peter Conti-Brown argued that the Fed’s policies have political implications, and therefore the bank should be accountable to the public through increased congressional oversight.

Another reason is that fiscal policy – a tool still controlled by national governments – is used with a light touch by politicians. Public spending programmes, once a standard response to economic downturns straight out of the Keynesian rulebook, are avoided for fear of a negative reaction from global markets. Structural reforms such as those taken by Germany in the early 2000s can ruin political careers: Germany’s Social Democratic Party still hasn’t recovered from the backlash against its Agenda 2010, a programme of welfare system and labour relation reforms that laid the groundwork for the country’s economic rebound. The result of instances like this is that central banks are left alone to pick up the pieces when things go wrong. In Europe, many central bankers have pushed governments to use fiscal policy to stimulate the economy and undertake structural reforms, but with limited results.

Facing contradictory demands, central banks often find themselves in a bind: when they step into the breach, as the Bank of England did after the Brexit referendum by cutting interest rates and pumping liquidity into the system, they are accused of interfering in politics. When they shy away from decisions that may have political repercussions, they are accused of inaction – often by politicians.

“The spread of populism has increased the temptation for politicians to misuse the central bank as a scapegoat for their own failures,” Otmar Issing, former ECB chief economist, told World Finance. “Central banks are widely seen as having become too powerful, which has undermined the acceptance of independence and reduced the threshold for attacks.”

Central banks’ power to intervene in global markets has also been overstated: although expected to have a cure for all diseases, they are frequently powerless in the face of forces they cannot control. Changes in national monetary policy often have little impact on areas such as international trade, fiscal policy or even the increasingly globalised financial system. Tucker said: “Central bankers, charged with maintaining a stable monetary system, need to be clear about what they can’t deliver, such as generating improvements in underlying dynamism (productivity growth), and stay close to base in their commentary.”

The next crisis
If there is one issue that attracts the ire of politicians, it is the figure that central banks are supposed to get right by default: interest rates. Following the crisis in 2009, central banks on both sides of the Atlantic have stuck to a policy of low interest rates in an attempt to increase money supply and stimulate the economy (see Fig 1). It is this aberration from economic orthodoxy that drives the current US president’s preference for low interest rates.

But the policy may have reached its limits, said Wachtel: “Persistent negative interest rates, such as the negative 10-year government yields in much of Europe, are unprecedented and should be a matter of concern. There is some natural real rate of interest – it is small but positive, and rates around the world have been below this for almost a decade.”

The problem has been more acute in Europe, where interest rates hit the symbolic threshold of zero in 2012 and turned negative in many countries two years later. The ECB’s loose monetary policy has caused a rift in its ranks between southern and northern countries; the former favour any measure that eases the burden of sovereign debt, while the latter bemoan the impact of low interest rates on spendthrift citizens and their savings. In his parting shot in September, outgoing ECB President Mario Draghi announced a further cut to a record low of -0.5 percent. The move caused an unprecedented uproar, with an open letter signed by former central bankers denouncing the ECB’s policies.

Issing – one of the letter’s signatories and a widely recognised architect of the euro – told World Finance: “With central bank interest rates still at zero and below, the ECB has missed the opportunity to create at least some room for action. In general, central banks with their asymmetric policy to react even on mild slowing of growth have continuously weakened their position in case of a strong downturn of the economy.” However, the ECB is unlikely to change course, said Frederik Ducrozet, an analyst at Pictet Wealth Management: “The ECB is de facto committed to asset purchases and negative rates for an extended period of time, around two years in our view, and at least until they see inflation ‘robustly converge’ towards the target… the balance of risks remains in favour of more monetary easing, not less.”

When central bank independence became a sacrosanct mantra of the financial system in the 1980s and 1990s, the goal was to tackle rampant inflation. The Maastricht Treaty required signatories to keep inflation at low rates, aiming to bring high-inflation countries such as Italy and the UK closer to the European average. This goal has been largely achieved: in the UK, inflation has fallen to an average of 2.3 percent over the last decade from its peak of 24 percent in 1975. Global inflation, meanwhile, has lingered at a moderate four percent on average over the past two decades (see Fig 2).

However, many economists warn that low inflation, or even deflation, is becoming a more worrying problem. Central banks have been constantly missing their inflation targets since the Great Recession, limiting the effectiveness of monetary policy. The reasons go beyond the remit of central banks, according to Danae Kyriakopoulou, Chief Economist at the Official Monetary and Financial Institutions Forum, a think tank specialising in central banking. She told World Finance: “The current environment of low inflation largely reflects structural factors that go beyond monetary policy and the actions of central banks. These include, for example, slowing productivity growth, weak demographics that create incentives for rising savings, and a scarcity of safe assets.”

One tool central banks have been eager to use to stimulate the economy is quantitative easing, a policy that was deemed unconventional until 2009. Over the past decade, central banks have vastly expanded their balance sheets by buying bonds and other assets. In Europe, the ECB’s balance sheet has reached the unprecedented rate of 40 percent of the eurozone’s GDP, and in September, the bank announced it will revive its €2.6trn ($2.86trn) bond-buying programme after a break of 10 months. The Bank of Japan has been following the same policy for decades, while the Fed has been pumping up liquidity through injections in the repo market.

Critics point to potential conflicts of interest, as central banks hold bonds and equities while they are expected to oversee the financial industry as a neutral regulator. “The extent to which the Bank of Japan and the ECB have been holding corporate and private sector bonds or equities creates risk that could be a concern,” Wachtel said. “The slippery slope is that they buy things to help out favoured elements of the economy. That makes the central banks no different than a government making bailouts or strategic investments.” A report by the Bank for International Settlements, released in October, found that oversized balance sheets may have distortionary effects on financial markets, including scarcity of bonds for private investors, squeezed liquidity and fewer market operators purchasing bonds.

By pumping money into markets, central banks may have created a bubble of private and sovereign debt that could spark the next  financial crisis

An even greater risk, according to critics, is that the financial system may have become addicted to cheap money. By pumping funds into markets, central banks may have created a bubble of private and sovereign debt that could spark the next financial crisis. When this hits the real economy, governments and central banks may be toothless, with budget deficits and public debts already at high levels and monetary policy having reached its limit. “There is broad evidence that the positive effects of quantitative easing have declined over time and might have given way to negative effects on market liquidity,” Issing said.

Challenges ahead
Central banks may have to enter the political fray through a completely different route: tackling climate change. Their role in dealing with the biggest challenge facing our planet has already become a hotly debated issue: in April 2019, Carney and the Governor of Banque de France, François Villeroy de Galhau, published an open letter calling for central banks to take a more active role in the fight against climate change, including measures to “integrate sustainability into their own portfolio management”. The new head of the ECB, Christine Lagarde, also favours a green agenda, promising to make this a key priority of her tenure during a confirmation hearing at the European Parliament.

Some central banks are already taking action. In November, Sweden’s central bank ditched bonds issued by oil-rich regions in Australia and Canada due to their high carbon footprints. The rest of the world’s central banks also have a role to play in the fight against climate change, Tucker said: “In their stress testing of the financial system, in order to see how far essential services (payments, credit supply, insurance) would be interrupted under certain scenarios. That’s the purpose of central banking: systemic safety and soundness.”

Many economists and politicians go one step further, advocating green quantitative easing that would push central banks to favour green bonds – fixed-income financial instruments with a strong environmental focus. Critics point to the limitations of the policy: although the issuance of green bonds surpassed the $200bn threshold in October, this remains a small fraction of total bond issuance. A bigger threat, others warn, is the politicisation of central bank decision-making through the back door. In October, Jens Weidmann, head of Germany’s central bank, rejected the use of monetary policy to support a climate-focused agenda, arguing that green quantitative easing would threaten market neutrality and undermine central bank independence.

But some change in central bank preferences might be inevitable, Kyriakopoulou said: “It is contradictory for central banks to have ‘brown’ [polluting] industries overrepresented in their portfolios on the pretext of market neutrality at the very same time that the governments they serve have signed the Paris Agreement, committing them to limit the increase in global average temperatures to below two degrees.”

Such an approach would finally break the taboo of central bank independence. Tackling a climate-driven economic crisis might be a task that is too political in nature to be left to unelected economists. Central bankers may well find themselves returning to square one, having to steer monetary policy towards certain forms of economic activity. This is where politicians might have to step in, Tucker said: “The big decisions on that would best come as legal constraints imposed by elected politicians. Otherwise, unelected central bankers would be making society’s trade-offs [on its behalf], which is adventurous without a democratic mandate. What’s at stake here could hardly be greater.”