It is difficult to know what is in anyone’s mind when they change their view or make a decision. They may be telling the truth when they give us their reasons related to the data. It is nonetheless a good idea to remember how many political pressures there are for lower rates, and how Federal Reserve (Fed) members must live in the Washington bubble and from time to time explain themselves to Congress and the Treasury Secretary.
European Central Bank (ECB) members live all the time with the knowledge that the Euro-area economy is not performing well and with the worry that borrowing rates diverging in weaker countries would be a bad development. They need to be staunch defenders of the Euro which is a very political project. As one once said, they need to do whatever it takes to ensure the Euro’s future.
Most professional investors tell their clients that many central banks are independent. They tell them this means politicians cannot meddle with their decisions. This means the choices are better and more firmly anchored on keeping inflation down, the prime target of their policies.
The Federal Reserve, the European Central Bank, the Bank of England and others have 2% inflation targets and constitutions that give their Monetary Policy Committees the power to decide what bank base rates should be.
This consensus view is supported by identifying cases where a government interferes to keep rates too low, leading to a faster inflation. Turkey is a recent bad example where President Recep Tayyip Erdoğan wanted faster growth. He changed the officials at the central bank if they did not help and made clear they were to keep rates below the level they thought appropriate. The result was a serious case of inflation, with the rate rising to 61.98% in November from 61.36% in October of 2023.
Cracks in the orthodoxy
Over the last three years, inflation soared to a peak around 10% in the US and Europe. This has led some to ask why did this happen? Why didn’t the independent committees rein in money growth earlier and put up rates sooner?
China, Japan and Switzerland did not experience the same rapid inflation as the US and Europe. The Bank of Japan did not increase its money creation and bond buying across the pandemic, Switzerland did not buy a huge bond portfolio whilst China avoided all quantitative easing bond purchases. These experiences show there were other policy options that worked better.
The problem with this for the consensus view is the Chinese and Japanese central banks work much more closely with their governments than the Western ones. In Japan, the previous monetary expansion was a stated part of government policy. The People’s Bank of China (PBoC) makes clear in all its statements that it follows the direction of President Xi Jinping and is a fully integrated part of government in the conduct of economic and anti-inflation policy. Investors have other reasons to worry about the authoritarian government in China and some of its actions, but they do not worry about political interference with the PBoC leading to a poor inflation outcome.
Overriding the central bank
One of the most successful periods of central bank independence was the post-war experience of the German central bank, the Bundesbank. For many years, German economic policy delivered good growth, and the Bank delivered low inflation. Politicians kept out of interest rates and monetary matters.
When East and West Germany were reunited on the fall of the Berlin Wall, the Bundesbank was overridden in its advice over the exchange rate and other arrangements for the switching of the ostmark, or East German mark, into Deutschmarks when the currency from the former communist area was abolished.
Most central banks are owned by the state they represent.
Though this valuation was a crucial issue for anti-inflation and monetary policy the politicians decided wider political issues took priority. An even bigger override occurred when the Bundesbank was instructed to end the Deutschmark, accept the euro and become part of the European Central Bank system. These were reminders that central banks – however apparently independent – are really arms of the state.
In October 2008 – the midst of the banking crash of 2008-9 – governments intervened, initiating coordinated interest rate cuts and other measures as central banks had been running policies which were too tight, threatening the whole financial system. On this occasion, the political interventions were entirely necessary and helped lead to a resolution of the banking disaster which monetary policies by central banks had helped create.
Most central banks are owned by the state they represent. The ECB is owned by member state's central banks, which are in turn owned by their national governments. The heads of these banks are usually appointed by the government. Other senior appointments may be made by the government or the head of the central bank under the watchful eye of the government.
Governments can alter their remit, their constitution and their structure as they see fit. If a central bank gets into financial trouble it would turn to the government to refinance it. The heads of central banks must report to a parliament or congress and be cross-examined on their policies and actions. Central bank senior personnel have regular private exchanges with the governments with which they work.
The independent banks live within a very political world. Their decisions will have major economic consequences, and economic outturns often dominate the wider political debate. The surge in inflation in the US and Europe became a major problem for incumbent governments which had to respond. The central banks were dragged into the debates as they were set up to control inflation as their number one objective.
The Fed has received two new Democrat vice chairmen appointed by President Joe Biden as he is entitled to do. The board must take into account the policy aims of the administration. Doubtless, there is regular contact between Treasury Secretary Janet Yellen and the chair of the Fed. It is usual for treasury secretaries and finance ministers to have private meetings with top central bank people, to discuss the way monetary and fiscal policy will interact and to seek agreement over how a common policy can work best for the national economy.
Central bankers are only human
The typical central banker has no more insight into what future inflation and growth will be than any well-trained economics professional in markets. They study the same data, read the same works, use similar models. The central bank may have the advantage of earlier sight of data, and may have an inside track from government – and sometimes that is rightly not available to others. It does not have a special crystal ball.
Its forecasts are more hampered than some private sector ones. With a 2% inflation target, the majority of central banks forecast 2% as the inflation rate two years ahead most of the time. If they did not, they would be under more pressure to change policy than they already are. They seem to accept two years is the kind of time it takes for rate changes to fully work through to get the desired effects. That allows them to forecast higher inflation over shorter time periods when it is obvious that is happening.
Central bankers need authority in markets. Sometimes they are good – they are ahead of events and can lead or influence the markets accordingly. Other times they get it wrong, misreading economies and following markets. Just as markets have to change when central banks assert a new truth, so central banks often change when markets insist they are wrong.
The Fed will say its policy is working so it can start to forecast falling rates. That is good news. Others might say the Fed was forced away from predicting rates staying higher for longer by market pressures. The markets have been saying for some weeks the rates have to fall next year. Democrats will breathe a sigh of relief that the Fed now thinks rates will be lower by the presidential election in a year’s time.
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