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Maybe central bank independence isn’t all it’s cracked up to be

Jerome Powell has inadvertently highlighted why the days of unquestioned central bank independence may be numbered

Price stability? Ha! Who cares about that, right? Inflation targeting is so last millennium. We’ve got a crisis on our hands, and there’s a very good chance we may have to run the economy hot to drag ourselves out of this hole. And if this results in a bit of extra inflation, well, that certainly won’t hurt everyone’s massive debt piles, now will it?

So said Jerome Powell, the chairman of the Federal Reserve, on Thursday (I paraphrase and extrapolate only slightly) in his speech to the Jackson Hole monetary policy symposium, the annual central banking jamboree, which, like so much this year, is being held virtually. The Fed will now use an average inflation target that gives it the freedom to overshoot the old 2pc target without having to immediately slam on the brakes by hiking interest rates.

Powell is attempting to address exactly the conundrum predicted by Charles Goodhart, an economist who used to sit on the Bank of England’s Monetary Policy Committee, in an article written earlier this year. He anticipated that the measures then being rolled out to tackle the sharp slowdown caused by Covid-19 could lead to higher inflation in the years to come, which would, in turn, lead to further difficulties for policy makers.

“Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile,” he wrote. “And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their 'independence'.” (The inverted commas are Goodhart's own.)

Powell would argue that he is prepared to keep interest rates low and tolerate higher inflation because it is the right thing to do rather than because he is worried about facing political ire. But we’re entitled to ask what difference the motivation makes if the end result is the same.

Around the same time as Goodhart’s article was published, Citi economists penned a note for clients in which they discussed how central banks and governments were likely to team up to battle the coming storm.

“Coordination between monetary and fiscal policy is particularly powerful when central banks are close to the lower bound [which is when policymakers have limited capacity to stimulate economic growth because short-term nominal interest rates are at or near zero]," they wrote. "The UK is better placed than the US or the eurozone to exploit this, in our view, given an arguably less independent central bank.” 

In short, there are economists in the City who think that the Bank of England is less independent than other central banks and, crucially, consider this to be a good thing.

Bank of England Governor Andrew Bailey

At this point it’s worth reminding ourselves of the reason why central banks were granted independence in the first place. Price stability could be considered a common good. If you have no idea what your pounds or dollars will be worth a few years hence it is very hard to plan for the future, to know whether to invest in your business and to decide what assets to put in your pension pot. 

All other things being equal, slow and steady inflation also lowers borrowing costs for governments and mortgage borrowers alike. Central banks were made independent to prevent politicians from mucking things up for everyone by cutting interest rates too far or overspending in the run up to elections as a none-too-subtle bribe to voters. 

This is all well and good in theory. In practice, there has been only small amounts of relatively steady inflation throughout the western world for years. Many central banks have struggled to hit their targets let alone worry about overshooting them. 

In fact, since the financial crisis, central bankers have lamented that they’ve been left to do all the heavy lifting in trying to drag the global economy out of its protracted slump and more or less begged their governments to put their shoulders to the wheel by loosening the purse strings with fiscal policies that complement increasingly ineffective monetary policies. 

In other words, central banks have been asking governments to do exactly the things that central bank independence was supposed to prevent them from doing. And then the global economy got side-swiped by a pandemic and central banks did in fact work hand-in-glove with governments to roll out policies that, while entirely necessary and appropriate, may well lead to soaring inflation.

Proponents of independence will argue that the fact central banks haven't defied governments (either through choice or circumstance) is less important than the fact they could. Independence acts like a cane sitting in the corner of the headmaster’s study, gathering dust while nevertheless still in the eyeline of potential miscreants. But the comments by Goodhart and those Citi analysts suggest they are beginning to suspect the headmaster is bluffing. 

Either way, there are bigger issues at play here. Central banks set short-term interest rates. Raise them and you help savers (who are usually older) and hurt borrowers (who are usually younger); lower them and you give borrowers a leg up at the expense of savers.  Powell is leaning towards keeping rates lower for longer. The issue is not whether he is right or wrong; the issue is that the Fed has unilaterally altered its mandate without the American people having a say in a decision that will have profound implications for all of them.

Monetary policy has undoubtedly boosted asset values at a time when the underlying economic fundamentals are weakening. This ensures the “haves” have more and the “have-nots” have less, relatively speaking. What this all boils down to are questions of intergenerational fairness. And, really, what could be more political than that? 

Outsourcing important issues such as these provides politicians with ready-made scapegoats when things go wrong. We are left with a “heads-I-win-tails-you-lose” situation in which Donald Trump can claim the credit when stock markets rise and blame the Fed when they fall. 

It's all part and parcel of an insidious trend in public life. And as with “following the science” to deal with the Covid-19 pandemic and laying the A-level fiasco at Ofqual’s door, it might prompt electorates to ask what exactly the point of politicians is if not to make the big calls. 

If the really important issues are being dealt with by technocrats, quangos and regulators, then the stakes are dramatically lowered come election day. If the President isn’t taking any of the key decisions, what's to be lost by voting a DayGlo reality show host into the Oval Office? 

Fans of central bank independence argue that it is a necessary measure to shield our most important institutions from politicians like Trump. It’s at least worth asking the question whether central bank independence is one of the reasons why we get lumbered with politicians like Trump.