Central banks are setting new expectations for monetary policy that may be hard to reverse as they slide deeper into the realms of fiscal policy.
To save their economies from debt crises or slow growth, the Bank of Japan is uniting with a new government by aiming to lift inflation to 2 percent by 2015, and the European Central Bank stands ready to purchase bonds of stressed nations. The Bank of England now has more room to ignore price pressures and is discussing with politicians how to ease credit further, while the Federal Reserve has extended more than $1 trillion worth of unprecedented credit to a single industry: housing.
The defense for activism is that monetary authorities need to protect their inflation goals from the possibility of Japan- style disinflation if governments don’t boost demand. The risk is they’re left doing the work of those governments -- or even financing them, creating precedents they may be pressured to extend or repeat in the future.
“Central banks have to be very careful in what they’re doing,” Axel Weber, chairman of UBS AG, told Bloomberg Television on March 27. “There is a challenge that their independence may be undermined simply because they’re getting closer to fiscal policy and politics.”
Weber resigned as president of the Bundesbank in 2011 partly because of his opposition to the ECB’s purchase of sovereign assets.
The role of central banks will be front and center in Washington this week when officials gather for the spring meetings of the International Monetary Fund. Maintaining independence is key to controlling inflation expectations, the IMF said April 9, and in an April 11 report, it urged authorities to remain vigilant to negative side effects from what it called their “unprecedented intervention.”
“Central banks are now doing something that if you asked 10 or 15 years ago whether they should, people would have said emphatically not,” said Alistair Darling, the U.K.’s chancellor of the exchequer from 2007 to 2010. “They are not targeting inflation any more, they are targeting growth.”
The shift has been accelerating since the outbreak of the global financial crisis in 2008 and marks a rejection of the rigid monetary orthodoxy that made low inflation a primary objective for central banks.
In the U.K., Japan, euro-area countries including France and Spain, and at least among Democrats in the U.S., politicians are looking to central banks to take greater responsibility for the health of their economies because fiscal policy is constrained and dragging on expansions.
The Fed’s $85 billion in monthly bond buying is leaning against fiscal tightening. The U.S. Congressional Budget Office estimates that federal outlays will fall to 21.5 percent of gross domestic product by 2017 from 22.8 percent last year and 25.2 percent in 2009.
According to research by Tom Lam, chief economist at DMG & Partners Securities in Singapore, for every one percentage-point rise in the projected ratio between the U.S. budget deficit and gross domestic product, yields on U.S. 10-year notes rise 24 basis points. The yield was 1.68 (USGG10YR) percent at 5 p.m. on April 15 in New York, according to Bloomberg Bond Trader prices.
“It is politicians who abdicated their responsibility for dealing with a whole host of regulatory and fiscal issues that put central banks in this situation,” said Michael Hanson, senior U.S. economist at Bank of America Merrill Lynch in New York, and a former Fed staffer. They “have gone far beyond what most people thought their role was.”
The 1997 decision to hand the Bank of England independence may have reduced the extra yield investors demand for inflation risk by as much as 150 basis points as measured by long-dated breakeven rates, estimates Philip Rush, an economist at Nomura International Plc. in London. The U.K. 10-year breakeven rate, an index of inflation expectations, traded last week at the highest level in more than 4 1/2 years.
Not all central banks have drifted from their mandates. The Bank of Canada maintained its focus on inflation throughout the crisis period and began raising interest rates in June 2010, saying it its actions were “consistent with achieving the 2 percent inflation target.”
The Reserve Bank of Australia cut its benchmark rate to a half-century low during the crisis, then raised it to a developed-world high of 4.75 percent in 2010 to contain inflation as the biggest resource-investment expansion in more than a century spurred hiring.
Fed Chairman Ben S. Bernanke laid the groundwork for active fiscal-monetary cooperation in May 2003. In a speech on Japanese monetary policy, he said the government could cut taxes for households and businesses and the Bank of Japan could buy government debt, in effect financing the deficit. Or the Bank of Japan could buy government debt to finance “industrial restructuring.”
“It is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments,” Bernanke said. In times of deflation, “a more cooperative stance on the part of the central bank may be called for.”
He didn’t describe in the speech how the central bank would re-establish its independence relative to the politically controlled fiscal authority once the crisis ended.
Now, central banks’ more explicit targeting of economic growth or segments of financial markets could produce a backlash. Legislatures could take a greater interest in monetary-policy decision making or ask central banks for even more direct support of industries or federal programs. Republicans in the U.S. have continuously championed an audit of U.S. monetary policy, making it a plank in their 2012 presidential platform.
Also, larger balance sheets take on interest-rate and credit risks that might reduce payments to taxpayers as central banks sell these assets when interest rates rise. They typically return profits they make on their portfolios to their national treasuries, supplementing government revenue.
Some members of the U.S. Federal Open Market Committee have been “concerned that a substantial decline in remittances might lead to an adverse public reaction or potentially undermine Federal Reserve credibility,” according to the minutes of the March 19-20 meeting released April 10.
The Bank of England in November said it would transfer about 35 billion pounds ($54 billion) in income to the Treasury from gilts it had bought. The potential hazard is a loss when interest rates gain, requiring money to flow in the opposite direction. A study by the U.K. central bank last month estimated the purchases could end up costing taxpayers 8 billion pounds.
Central banks also may obscure the cost of fiscal imbalances by keeping long-term interest rates low, reducing pressure on politicians to regain budgetary control. Even some Fed supporters in Congress lament the extremes monetary policy has taken because of the lack of better fiscal policy.
Political systems too often “just default to the central bank” because it becomes tough to make hard fiscal choices, Senator Mark Warner, a Virginia Democrat, said in an interview March 21. “At the end of the day, we should be making the hard choices, not the central bankers.”
Central bankers aren’t blind to the risks and regularly warn that monetary policy alone cannot fix economic ailments.
“I am not surprised by the questions that have arisen about our independence and, around the globe, about the governance arrangements around central banks,” Richmond Federal Reserve Bank President Jeffrey Lacker said in response to a question from Bloomberg News April 9. “The scale and scope of our intervention in 2008 went well beyond what people expected.”
Lacker opposes the Fed’s purchases of mortgage-backed securities because the program targets monetary policy toward a single industry.
Some central banks may find themselves with little option but to keep pulling the monetary levers or risk deeper economic pain. Not acting also could risk the credibility of banks including the Fed and Bank of Japan.
The Fed has an explicit mandate from Congress to achieve “maximum employment” as well as price stability. The jobless rate was 7.6 percent in March, above the 5.2 percent to 6 percent rate Fed officials estimate represents full use of labor resources.
The Japanese central bank is working closely with the government after Prime Minister Shinzo Abe won power in December, counting monetary stimulus with fiscal spending and deregulation as the “three arrows” aimed at reversing 15 years of falling prices.
Abe nominated Haruhiko Kuroda to replace Masaaki Shirakawa as governor, and the bank said on April 4 that it will double monthly bond purchases to 7.5 trillion yen ($78 billion) with the aim of doubling the country’s monetary base and achieving 2 percent inflation within two years. This will mean buying the equivalent of 70 percent of the government’s new bond issuances each month. Abe says changing the law governing the central bank is an option, signaling he could remove its freedom to set the policy target if it fails to revive the economy.
“The cooperation to conquer deflation between the government and the BOJ has never been stronger,” said Masamichi Adachi, senior economist at JPMorgan Chase & Co. in Tokyo and a former BOJ official. “The Japanese public are frustrated with the state of Japan’s economy. In that sense, the BOJ doesn’t have independence any more.”
The ECB, initially viewed by the euro’s founders as an offshoot of Germany’s proudly independent Bundesbank, also is fueling tension over how far it’s willing to help governments battle a debt crisis that has just taken Cyprus as its latest victim.
Having already bought government bonds to soothe markets, made unlimited long-term loans to banks and diluted the quality of acceptable collateral, President Mario Draghi last year crafted the Outright Monetary Transactions program, which allows the ECB to buy the bonds of nations that agree to austerity and to revamp their economies. He says doing so would help unblock bottlenecks that prevent the central bank’s easy-money stance from filtering equally through the 17-nation region.
As yet untapped, it has been opposed by Bundesbank President Jens Weidmann on the grounds that it’s tantamount to printing money to finance governments, which the ECB’s founding treaty prohibits. Underscoring German disdain, former ECB board member Juergen Stark, who quit in 2011 in protest at the first round of bond buying, dubs the strategy “Out of Mandate Transactions.”
“The ECB has made an amazing power grab on fiscal policy,” said Tim Duy, an economist at the University of Oregon in Eugene who writes a blog on monetary policy. “To what extent does this political intrusion prevent them from doing their job in the future?”
The independence dilemma may be greater for the ECB than its counterparts because “there is more incentive for an individual country to push risk on to the central bank, since that way it spreads the risk away from the country itself to the euro area as a whole,” said Huw Pill, chief European economist at Goldman Sachs Group Inc. and a former ECB official.
Some politicians already want more. Spanish Prime Minister Mariano Rajoy last week called on the ECB to match the quantitative easing of the U.S. and Japan. French President Francois Hollande has leaned on the ECB to do more to weaken the euro.
The government and central bank of Cyprus also are at odds over whether to sell the nation’s gold. Bundesbank board member Andreas Dombret warned in today’s Handelsblatt newspaper against politicizing central banks by handing them sole responsibility in areas requiring democratic legitimacy such as financial market supervision.
The fiscal and monetary authorities of the U.K. also may be blurring lines amid the risk of a third recession since 2008. The central bank already has tolerated inflation above its 2 percent target every month since November 2009 and has 375 billion-pound quantitative-easing program.
The ties may nevertheless be getting stronger as the economy stays weak. Calling “monetary activism” a necessary part of the government’s economic strategy, Chancellor of the Exchequer George Osborne last month made the bank’s mission statement more flexible and told it to explore Fed-style policy guidance to enhance stimulus after Mark Carney becomes governor in July.
The Fed in December tied changes in its benchmark lending rate directly to economic indicators for employment and inflation for the first time.
Osborne also said government and central-bank officials are “actively considering” extending the Funding for Lending Scheme they united to start last year. The goal is to boost the provision of credit by lowering funding costs for financial companies.
“There does seem to be an element of politicization” in the programs, said Robert Wood, chief U.K. economist at Berenberg Bank in London and a former Bank of England official. “But for the moment it’s not pushing policy where it shouldn’t be because the economy does need stimulus.”
The upshot is that the world economy is in a period when central banks are willing to restrain the cost of servicing government and household debt for fear of derailing economies if they don’t, said Joachim Fels, co-global head of economics at Morgan Stanley in London.
“Central bank independence is history,” he said.
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