13 November 2016

Financial Times: The end of the era of central bank independence

Central bank independence is premised on two conditions. The first, and more important, is that there is a broad consensus on the goals of monetary policy. The second is that an independent central bank board, usually staffed by professional economists, can deliver those goals. The first of these conditions is broken. The second is under a cloud.

The consensus of 1989-2016 — the golden age of financial globalisation — held that central banks should target a low positive rate of inflation. [...]

Mr Trump has openly challenged that consensus. His economic advisers have told the Financial Times that the US Federal Reserve had created a “false economy”, and that the president-elect wants to see someone at the top of the Fed who reflected his own views.

In the eurozone, the consensus in favour of the European Central Bank policy target of just under 2 per cent inflation has become fragile, too, albeit for different reasons. The German economic establishment never believed in it. Jürgen Stark, a former member of the ECB’s executive committee, says the European treaties only talked about the need to maintain price stability; they did not empower the ECB to translate this mandate into a numeric inflation target. His argument is that an inflation rate of 0-1 per cent, as at present, is perfectly consistent with the notion of price stability. As a result there is no case for negative interest rates to boost inflation, let alone for quantitative easing and other unconventional policies.

I predict that once the economy recovers and the ECB is forced to raise rates, Italian economists will call on the central bank to prioritise financial stability over price stability, given the fragility of Italy’s financial sector and the high level of public debt. In the eurozone, too, we lack consensus.

The important point is not whether those who challenge the policy consensus are right or wrong. The view of the economic establishment is that central bank independence is a good thing — not surprising since economists benefit personally from the system. I myself agree with those who argue that central bank independence is neither necessary nor sufficient for price stability.

But what really matters is that the consensus has broken down. If a sufficiently large number of people want the central bank to target the stock market, a happiness index or the weather instead of some measure of inflation, the argument for independence is lost. That alone means that monetary policy can no longer be relegated to independent experts. It should, and will, revert to what it was in many countries before the 1990s: an integrated function of a government’s broader economic policy.

I do not expect the end of independence over night or even in full. The eurozone will be most resistant because independence is written into European law and it is hard to see everybody agreeing to treaty change. A monetary union has no government for a central bank to be dependent on. The ECB will be the central banking equivalent of the last man standing.

The US and UK have weaker forms of central bank independence so change could come sooner. The first stage would be the appointment of politically compliant governors, and members of monetary policy boards more political than the current academic crop. This is how Mr Trump and Mrs May will subvert the system, not necessarily through the formal abolition of the concept of the independent central bank. [...]

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