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How to preserve the benefits of central-bank autonomy

Posted by hkarner - 28. April 2017

Date: 27-04-2017
Source: The Economist

Twenty years after the Bank of England was given independence, the powers of central banks are in the spotlight

ON MAY 6th 1997 Gordon Brown, freshly installed as Britain’s chancellor of the exchequer, announced that he was giving the Bank of England the responsibility for setting interest rates. The bank would be charged with meeting an inflation target set by the government.

The move was hailed as a political masterstroke. It gave substance to the new Labour government’s claims to economic competence. Long-term borrowing costs fell sharply. The pound soared. The bank’s governor, Eddie George, was delighted. But joy was not unconfined. Within weeks Mr Brown, wary of an over-mighty central bank, stripped it of its responsibilities for bank regulation and public-debt management.
Twenty years on, some fear that central banks have become too powerful. The Bank of England is back in charge of bank regulation. The European Central Bank (ECB) has added that job in the euro zone to a host of others it has picked up since the financial crisis. The Dodd-Frank act of 2010 gave America’s Federal Reserve authority to ensure financial stability. Central banks have acquired more tools to go with their extra tasks. But they have also come in for louder criticism. The Bank of England was bashed for its assessment of Brexit. The ECB’s quantitative-easing (QE) programme has been challenged in Germany’s courts. A bill in Congress calls for the Fed’s decisions to be audited. Savers moan about low interest rates.

The case for central-bank independence is as powerful as it was two decades ago. Interest rates need to be changed well before they will affect inflation. Politicians are loth to be pre-emptive. An independent central bank is more likely to act promptly to head off inflation—and this trustworthiness also affords it freedom to cut interest rates when recession looms.

Yet the critics should not be ignored. The history of central banks shows that their power can ebb and flow. Two of America’s central banks folded before the Fed was established; Lyndon Johnson and Richard Nixon were not averse to bullying Fed chairmen into keeping interest rates low.

In addition, the financial crisis of 2008 forced central banks to make controversial decisions, in part because many governments were unable or unwilling to act themselves. They rightly put their resources at risk to bail out banks and keep credit markets working. To counter the bust that followed took a long period of near-zero interest rates and schemes such as QE. But the uneven effects on individuals of this newer sort of monetary policy were stark. One of the more reliable effects of QE was to raise share prices, favouring the well-off. Low rates are a salve to the indebted but hit deposit-holders.

Trade-offs of this kind are not new. The task of choosing how many jobs to sacrifice in order to hit an inflation target sooner rather than later is highly political. Yet there are ways in which central-bank powers might be circumscribed without hurting the bit of their autonomy that matters.

One is to follow the British model, in which the government sets an inflation target for the central bank to follow. Society’s preferences over the “right” rate of inflation are not settled. It may sometimes be necessary to change the target. When low real interest rates are required, for example, it may make sense to aim higher on inflation. That is a decision for elected politicians. Ideally, this target should be symmetrical, meaning that inflation below the target is as undesirable as that above it. Otherwise, rate-setters who favour lower inflation have licence to indulge their preferences.

The old lady sings the blues
Preserving the legitimacy of independent central banks also relies on the actions of central bankers themselves. It is not possible to make the setting of interest rates perfectly neutral or to free central banking from all residue of politics. But wise central bankers would limit their public comments to their own bailiwick. It is fine to point out that a looser fiscal stance would imply higher interest rates; but it is not obvious what is gained when a central banker directly criticises, or endorses, a specific tax plan or spending policy. Straying onto broader policy issues, as Mark Carney, of the Bank of England, has on climate change and Raghuram Rajan, of the Reserve Bank of India, did about religious tolerance, is likely to irk politicians and squander influence better saved for the bank’s main tasks.

The benefits of central-bank autonomy far outweigh the costs, just as they did in 1997. The friction between politicians and bankers cannot simply be wished away. To keep the critics at bay, central bankers must be accountable for the powers delegated to them, and disciplined in their exercise.

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