With the global rise of populism and autocracy, central-bank independence is under threat, even in advanced economies. Since the 2008 financial crisis, the public has come to expect central banks to shoulder responsibilities far beyond their power and remit. At the same time, populist leaders have been pressing for more direct oversight and control over monetary policy. And while central banks have long been under assault from the right for expanding their balance sheets after the crisis, now they are under attack from the left for not expanding their balance sheets enough.
This is a remarkable shift. Not too long ago, central-bank independence was celebrated as one of the most effective policy innovations of the past four decades, owing to the dramatic fall in inflation worldwide. Recently, however, an increasing number of politicians believe that it is high time to subordinate central banks to the prerogatives of elected officials. On the right, US President Donald Trump and his advisers routinely bash the US Federal Reserve for keeping interest rates too high. On the left, British Labour leader Jeremy Corbyn has famously called for “people’s quantitative easing” to provide central-bank financing for government investment initiatives. “Modern Monetary Theory” is an idea in the same vein.
There are perfectly healthy and legitimate discussions to be had about circumscribing the role of central banks, particularly when it comes to the large-scale balance sheet operations (such as post-crisis quantitative easing) that arguably trespass into fiscal policy. However, if governments undercut central banks’ ability to set interest rates to stabilize inflation and growth, the results could be dangerous and far-reaching. If anti-inflation credibility is lost, governments may find it very difficult – if not impossible – to put the genie back in the bottle.
Complicating matters further, central bankers must figure out how to give normal monetary policymaking teeth at the zero lower bound, given today’s ultra-low inflation and real interest rates. The current reliance on quasi-fiscal policies is not only ineffective; it is also dangerous, because it lends weight to the argument that finance ministries should have more control over central banks.
Indeed, the primary challenge confronting central banks is not that they are too powerful, but that some see them as losing relevance. Inflation has been so low for so long that many have forgotten what it was like before independent central banks were established to rein in double-digit price growth. It has become increasingly popular to argue that low inflation is a hardwired feature of the twenty-first-century economy. And yet the complacent dismissal of future inflation risks – and thus of the need for central-bank independence – has all the hallmarks of the “this time is different” mentality that has been a recurrent feature of economic history.
Good Deeds, Punished
One need not travel far down memory lane to remember that dozens of countries were seized by high inflation (above 40%) as recently as 1992, and that the United Kingdom, the United States, and Japan all suffered through double-digit inflation in the 1970s. The influx of inexpensive Chinese imports and the advent of the computer age certainly helped to bring that era of epic inflation to an end. But all evidence suggests that the rise of central-bank independence played an essential role.
Starting in Europe in the 1980s, one country after another granted its central bank significantly more autonomy. With the International Monetary Fund now forecasting inflation of just 1.6% across advanced economies this year, many have begun to wonder if central banks are even capable of generating inflation again. There is, in fact, a serious question as to whether central banks have gone too far – concentrating too much on inflation fighting and not enough on developing adequate tools to fight deflation. I will return to this later. The main point is that inflation has now become so low that, from a political point of view, central banks risk becoming victims of their own success.
Aside from maintaining low, steady inflation, most central banks also face the challenge of ensuring macroeconomic stability; it is widely accepted that activist monetary policy has played an important role in smoothing out business cycles throughout the post-war era. In the case of the US, the Federal Reserve has responded to recessions with sharp interest-rate cuts of five percentage points or more, on average. Yet with the Fed’s policy rate at just 2.5% today, and with the European Central Bank (ECB) and the Bank of Japan (BOJ) already at the zero bound, cuts of that magnitude will not be possible when the next recession arrives.
What else can central bankers do? Not as much as most observers seem to think. The current monetary-policy debate suffers from a crippling confusion over the conceptual distinction between monetary and fiscal policy. At times, central banks have played a part in exacerbating this confusion, by overselling and mislabeling “alternative monetary-policy instruments.” Not only have these measures proven less effective than traditional interest-rate policies in stimulating output and inflation; they have also encroached on the fiscal-policy realm, where central banks are junior partners to treasuries and finance ministries. And they are very much at the heart of recent challenges to central banks’ independence.
Treading Water
Though early studies suggested that central-bank purchases of long-term government bonds – known as quantitative easing (QE) – after the 2008 crisis provided significant stimulus by pushing down long-term interest rates, it has since become clear that most of the action in long-term rates stemmed from an unrelated trend decline. Even where some effect has been found, it has arguably been due to a false belief on the part of investors that central banks were “printing money” and inflation was around the corner. This will not happen again. Today, much of the initial optimism toward QE has been sharply tempered – as it should be. When a central bank purchases long-term government debt by issuing overnight bank reserves with the same interest rates as very short-term Treasury bills, it is not “printing money,” but rather shortening the maturity structure of government debt. The problem, with respect to central-bank independence, is that treasuries and finance ministries are perfectly capable of doing this themselves; in fact, they do it all the time.