Mr Bernanke, put back that wall!

The quantitative easing and unconventional monetary accommodation policies followed by central banks in developed countries has undoubtedly shifted monetary policy into a largely unknown terrain. Though supporters assure that central banks have adequate instruments at their disposal to roll back when need arises, given the sheer size of expansion of central bank balance sheets and the massive quantities of liquidity being created, the concerns are well-founded.

The conventional wisdom on the issue of central bank independence has revolved around governments trying to keep a leash over their activities to maintain their freedom to indulge in seignorage (or printing money) to finance public spending. In this context, Alan Blinder points to an alternative reason why central bank independence may be in danger - the increased co-ordination between monetary and fiscal policy authorities. He says,

The question is whether there has been too much coordination between monetary and fiscal policy, not too little; whether the close cooperation between central banks and Treasuries has compromised central bank independence; and whether, therefore, this close cooperation should end promptly. If I may paraphrase Ronald Reagan, it’s: Mr. Bernanke, put back that wall.

He argues that the recent crisis forced central banks and governments across much of developed world to co-ordinate very closely to stabilize the financial markets and also to prevent economies from slipping deeper into recession. Central banks on both sides of the Atlantic deployed all the monetary policy instruments at their disposal in this endeavor. In fact, popular and large sections of professional opinion has been socialized into believing that central banks, more than even governments, hold the dominant policy cards for stimulating economic growth.

This is dangerous either way. If all these fail and the economy falls into a long-drawn recessionary trap, it will seriously erode the functional credibility of central banks themselves. This will have very adverse long-term consequences. After all, a large part of the effectiveness of monetary policy actions stems from rational expectations about the central banks' inflation targeting commitment.

And if the policies succeed and the economy recovers, then the central bank will be pushed even more into the center-stage of the larger economic policy making domain. Such an expanded role invariably comes with more political compulsions that may often conflict with its primary responsibility of maintaining price stability. For example, it may constrain central banks from leaning against the wind and pursuing counter-cyclical policies.

Furthermore, it could also aggravate the current disconcerting trend of national governments passing the buck on to central banks and refraining from taking the hard long-term structural reforms required for sustainable long-term growth.

In the circumstances, a careful re-examination of the role of central bank may be necessary for the long-term institutional health of central banks themselves as well as the effectiveness of larger economic policy making itself.