Thursday, November 26, 2009

Central Bank independence in peril?

One of the major, if not the biggest, casualties of the sub-prime crisis and the economic recession, with its resultant fiscal expansion driven increase in public debt, could well turn out to be increased oversight of Central Banks across the world and stronger curbs on Central Bank independence. The primacy of Central Bank monetary policy making in controlling inflation has been so much taken for granted that we may now be unwittingly dissipating it in the guise of exercising greater political oversight over all financial market regulators.

On the one hand, political executives have realized the critical role of Central Banks in reflating a depressed economy and may feel that they should exercise greater control over this function. On the other hand, the question marks over the failure of Central Bankers (especially the Greenspan Fed in the US) to "take away the punch-bowl as the party got going" (by say, raising interest rates), and the resultant asset price bubbles have raised a chorus of opinion that Central Banks themselves need to be more closely regulated.

In the circumstances, as Free Exchange noted, albeit in a different context, the challenge is to "influence the Fed, while simultaneously keeping it independent". Unfortunatley, it is increasingly becoming clear that in order to achieve the former, the later is being compromised.

It therefore comes as no surprise that the US Congress is debating controversial proposals with far-reaching implications on the Federal Reserve's independence, to clip the Fed's regulatory authority, to change the selection process to key posts in the Federal Reserve system, and to audit its monetary policy decisions and dealings with foreign central banks.

The always incisive Mark Thoma expresses the concern that dilution of Central Bank independence and greater control by the political executive could seriously compromise the only credible policy instrument available to address inflation and unleash "political business cycles". There are three ways to finance deficits - government raising taxes, government issuing debt, and the Central Bank printing money. Of the three, the first is politically suicidal, especially when the economy is not doing well (precisely when such deficits are likely to be large), the salience of the second option invites policy criticism (on grounds that it would drown the future generations in debt, and also crowd out private investments by sucking in all available savings). Governments, especially those facing elections in the immediate future therefore prefer not to exercise these two policy choices.

This leaves printing money as the most attractive option, since its immediate impact could be positive on the output. This option, popularly called debt monetization, takes place outside public glare and its immediate implications are benign and longer term consequences not easily evident. Since inflation takes effect with some lag, there is no immediate adverse impact from injecting money supply into the economy. Printing money also offers the superficial attraction that the expected inflation would erode off the burden of debt and depreciate the currency, all the more attractive given the burgeoning public debts and intense trade competition posed by China with its weak-currency policy.

Under this, the Central Bank prints money and then offloads it into the market by purchasing long-term government securities. The net result is that instead of the government (or Treasury in the US), the Central Bank now holds the debt, and it pays for its operations from its earnings on these bonds and remits the remainder to the government. Further, the purchases of government securities pushes up their yields (lowers their prices) and puts upward pressure on interest rates. And as the increased money supply finds its way into the market, inflationary pressures soon get triggered off.

Anil Kashyap and Frederic Mishkin argue that any audit of the Fed's monetary policies would cripple policy making on inflation. They also feel that the publication of the minutes of the interest rate setting committee (the FOMC) meetings, periodic reports and often gruelling testimonies of its officials ensures adequate transparency in Fed's policy making, besides giving the executive enough supervisory control.

Alan Blinder feels that Central Bank independence has "enabled the long time-horizons of technocrats to triumph over the short-term perspectives of politicians", and kept inflation under control over the decades. He argues that any dilution of this independence would result in political monetary policy prevailing over technocratic monetary policy with disastrous long term consequences.

Many prominent economists have expressed firm support for the policies of the Fed and feel that its aggressive and unconventional monetary policy actions saved the economy from slipping into a repeat of the Great Depression. However, the Fed's concerns with inflation and reluctance to indulge in more monetary easing in the face of soaring unemployment is causing atleast some consternation and the voices would grow louder as the economy worsens, even if slowly.

Free Exchange echoes the views of those who favor some controlled dose of inflation as a means towards a counter-cyclical reflation of the economy. They argue that in the face of a zero-bound liquidity trap, the Fed should consider abandoning its obstinacy with the 1.7-2% inflation target and explicitly target a higher, say 4%, inflation target to bring in some traction into the floundering economy.

Tim Duy has an excellent summary of the existential dilemma facing the Federal Reserve in the US. In light of the events of the past decade, amplified by the high-profile moral hazard creating bailouts of the last twelve months, a strong and difficult to erase impression has gathered ground that the Fed works for Wall Street and not the Main Street, leave alone Joe and Jane. Restoring even a small sliver of faith, atleast among the public and threreby warding off attacks and encroachments from the public representatives, would require a leap of faith and an explicit declaration of concern about the problems created by unregulated financial markets, its various incentive distortions and other systemic failures. Paul Krugman too feels surprised by the Fed's reluctance to support junking shadow banking and returning to traditional banking.

See these excellent posts on Central Bank independence here, here, here. See also this nice summary of Central Bank independence and the challenge facing the US Federal Reserve by Henry Kaufman.

Update 1
Mark Thoma has this superb explanation of the interaction between budget deficits and inflation and Central Bank autonomy. Central Banks can keep interest rates constant by monetizing the debt by expanding the money supply through open market operations - the central bank prints money and uses it to purchase government bonds held by the public causing the money supply to expand and the debt to contract.

Update 2
The House Financial Services Committee has passed a measure that would subject the Fed's interest-rate decisions to scrutiny by the Government Accountability Office.

See also this article that debates a change in strategy - from mopping up after a bubble bursts with lower interest rates to cushion the blow to the economy and restart growth, to one that identifies bubbles and takes action (raise rates) to prick it before it gets inflated. This proposed change comes against conventional wisdom, expemplified by Bernanke himself, who had argued in a famous 1999 paper that central banks should focus on controlling inflation and should desist from smoothing the booms and busts of business cycles and trying to prick bubbles.

Update 3
See this NYT article on the court case being pursued by Bloomberg News, which had filed a Freedom of Information Act request with the Federal Reserve Board seeking the details of its unprecedented efforts to funnel money to the collapsing banks of Wall Street, and which was rejected by the Fed.

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