Macro

William Martin is the longest-serving Federal Reserve chief, having served from 1952 when Harry Truman was president to 1970. A few years into the role, Truman saw Martin on a New York street. The president from 1945 to 1953 stared at Martin, called him a “traitor” and walked away. Martin’s betrayal? He prioritised a successful fight against inflation running at an annualised 21% in 1951, rather than help Truman fund the Korean war by ensuring Washington could borrow at 2.5% or less.

Lyndon Johnson, the fourth of Martin’s five presidents, got frustrated with him too. Johnson enacted fiscal stimulus in 1964 only to see the Fed resist his bullying to keep interest rates low. In 1965, Johnson summoned Martin to his Texas ranch where the president “shoved him around his living room, yelling in his face: ‘Boys are dying in Vietnam and Bill Martin doesn’t care.’ When Martin’s final term ended, inflation was 6% and heading to double-digits.

Now President Donald Trump is treating the Fed with similar disrespect. Trump has publicly criticised the “going loco” Fed led by “clueless” “enemy” Jerome Powell about 50 times since mid-2018 over high interest rates and nominated supporters of questionable fit for the Fed’s policy-making board, amid reports he considered sacking his appointee to lead the central bank.

The worry is that Trump is just another menace to the practice whereby central banks set monetary policy to meet inflation and other targets supposedly free of political pressure. Bloomberg counts that 17 central banks faced political interference in 2018. The number includes the European Central Bank that was attacked for radical remedies such as negative rates and for buying government bonds. The Bank of England featured for issuing forecasts unflattering to UK’s future outside the EU – one Conservative MP in 2019 called Governor Mark Carney a “second-tier Canadian politician” engaged in “Project Hysteria”. Conflicts last year between the Reserve Bank of India and the government led to the governor’s resignation. This year, the head of the Central Bank of the Republic of Turkey was sacked over policy disputes. 

Many forces are combining to weaken the autonomy of central banks. Populists are targeting central banks because the global financial crisis discredited the neoliberal framework of which their independence is a part. Central banks have been given more tasks, often bank supervision, that come with controversies. Central bankers are commenting on politically sensitive topics such as climate change and gender quotas. Critics claim their asset-buying programs have boosted inequality by inflating asset prices (even when conceding such tactics staved off recessions).

But two other reasons stand out that point to the trend intensifying because they relate to the merits of independent monetary policy as a way to manage economies. The first is the raison d'être for independent central banking is waning; low inflation means politicians have lost their incentive to outsource the blame for higher interest rates. The second is that orthodox monetary policies are exhausted and people realise monetary tools can’t be radicalised much more because they promote risks; namely, they inflate asset prices, hinder lending and squeeze bank profits (which increases the risk of financial instability). 

To overcome this failure of monetary policy to fire sustainable growth, policymakers are pondering fiscal solutions that would dilute the autonomy of central banks.

Japan’s experience shows how political and economic conditions can force action that curtails central-bank freedom. Many argue the Bank of Japan lost its autonomy in 2013 when it became part of Prime Minister Shinzō Abe’s drive to refloat Japan’s deflation-ridden economy. A central feature of ‘Abenomics’ is it blurs the distinction between monetary and fiscal policies, which were separated to stop the inflation-prone practice whereby central banks bought government bonds directly from Treasuries to fund fiscal deficits.

As Japan’s fight against deflation shows, the weakening of central-bank autonomy can be an appropriate policy response. But the loss of central-bank autonomy could come at a cost, especially if it’s judged to be due to political pressure rather than economic circumstances. The policy to convince investors and the public that central banks were above the political fray reduced the level of uncertainty in asset prices and instilled public faith that inflation would stay tame, fiat currencies would hold their worth and central banks would act for the common good. If central-bank autonomy were to erode, such investor and public confidence could be hard to restore.

To be sure, most central banks only enjoy a ‘quasi independence’ – some analysts even call central-bank independence a “myth”, however, John Howard might have disagreed when the Reserve Bank of Australia raised rates during the formal campaign of the 2007 election his government lost. Central banks are entwined in politics because they form part of the executive and they often cooperate with Treasuries, as happened in the US during the global financial crisis. Lawmakers set goals for central banks that can be revised any time. They make central bankers report to parliaments. Many central-bank leaders need to maintain public and parliamentary support to ensure their reappointment. The record of ‘apolitical’ central banking has blemishes. The biggest are the global financial crisis and the ECB’s rate increases of 2010 that intensified the eurozone debt crisis.

Whatever their errors or the degree of autonomy, granting central banks independence was an apt political and policy solution when inflation was a threat. Today’s low-inflation, low-growth and high-debt world will likely call on fiscal remedies that erode central-bank autonomy. 

The faster central banks exhaust their orthodox options, the sooner comes the day when investor and public faith in these solutions is tested.

Genuine or quasi

German Chancellor Helmut Kohl (1982-1998) wanted a single currency for Europe as his legacy but knew Germans preferred to keep the Deutsche mark. Kohl’s solution was twofold. He created rules around fiscal deficits to assure Germans they would never need to bail out other euro countries. The other was to ensure the ECB be set up without any political oversight to ensure independence to meet its sole goal to control inflation.

The ECB’s treaty-protected independence harked to the establishment of the Bundesbank in 1957 as the world’s first independent central bank as required by Germany’s constitution of 1949. The Bundesbank’s freedom to safeguard price stability become more overt after Bretton Woods collapsed in 1973 and fiat currencies were floated. Essentially, political and policy imperatives drove these developments; namely, to guarantee Germans would never again suffer the hyperinflation of the early 1920s and straight after World War II.

The Fed’s shift to a de facto independence is another outcome of political and economic circumstances. The watershed was the Treasury-Federal Accord of 1951, which ended the role the Fed undertook at the start of World War II to buy government bonds to ensure Washington could borrow cheaply. The Fed emerged from Treasury servitude because the central bank needed to fight the price increases caused by its financing of Washington’s spending on the Korea war. Inflation soared at the time due to the absence of the price controls used in World War II.

The next notable step to quasi autonomy was when the double-digit inflation of the 1970s prompted Congress to pass the Federal Reserve Reform Act of 1977, which tasked the Fed with the goals of price stability, full employment and moderate interest rates. (The last goal, a subjective one, is overlooked and the law is known as the ‘dual mandate’.)

In 1979, Paul Volcker at the start of his eight-year stint as Fed chief used this law to convince the administration of Jimmy Carter that the Fed needed to haul in inflation running at an annualised 11% to ensure full employment over the longer term.

Volcker crushed inflation – though at the cost of the 1981-1982 recession – and his triumph inspired other countries to grant their central banks ‘autonomy’ to control price increases. New Zealand in 1989 became the first country to do so. Canada followed in 1991. Australia, where Paul Keating boasted in 1989 that the RBA was “in his pocket”, did likewise in 1996. The UK followed in 1997 and Japan in 1998.

But now this quasi independence could fray as policymakers confront a low-inflation, even deflationary, world where growth is challenged, debt is high, trade barriers are rising and asset prices are at record highs.

On July 23, the day Boris Johnson became the new leader of the Conservative party, Andy Haldane, the Bank of England’s chief economist, had a warning for the new prime minister. The government can’t expect the “monetary cavalry” to rescue the economy, Haldane said. “A decade ago ... monetary policy was the right prescription. The game has changed. The right medical prescription (now) is fiscal and structural policies.”

As policymakers turn to fiscal policy and executive fiat to promote sustainable more-equitable growth, central bankers might morph into public servants whom Truman would consider loyal and to whom Johnson would be friendly. But investors and the public might trust them less, especially if the loss of autonomy occurs while Trump is tweeting against the Fed.

By Michael Collins, Investment Specialist

Want to learn more?

We believe that successful investing is about finding, and owning for the long term, companies that can generate excess returns on capital for years to come. To keep up to date with Magellan's latest thinking, hit the follow button below. 



Comments

Please sign in to comment on this wire.