Have Central Banks Lost Their Independence?
In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
Many other countries have modeled their Central bank operations after the Federal Reserve in hopes of maintaining economic stability. Over the years, the tools used by the Fed and other Central Banks to achieve the congressional mandate have varied. Until recently many would argue that Central Banks, at least in the US, have been largely independent of political pressures. This independence from political pressure is significant as political control of the Fed would lead to an ever growing money supply. Increasing the money supply increases political opportunity for reelection as it falsely gives the impression of economic growth. This results in uncontrolled inflation that eventually kills economic growth.
The most common tool used by Central banks is the manipulation of interest rates. When the economy expands interest rates are increased to control inflation. When the economy contracts, interest rates are lowered to spur economic growth. In 2007, former Federal Reserve Chairman Alan Greenspan commented that “The Federal Reserve may have to double its benchmark interest rate to at least 10% by 2030 to stem inflation, sparking a political showdown that could challenge its independence. Federal Reserve independence is not set in stone. The dysfunctional state of American politics does not give me great confidence in the short run” and there may be “a return of populist, anti-Fed rhetoric.”
The significance of Greenspan’s comments lies in the independence of the Federal Reserve and Central banks around the world. Economist Frederic Mishkin wrote: “Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed’s independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.”
Is the independence of the Fed already being threatened? In 2009, there were several bills proposed in Congress directed at the Federal Reserve. The two most prominent proposals were Senate Banking Committee Chairman Christopher Dodd’s bill to take away most of the Fed’s regulatory authority, and Congressman Ron Paul’s bill to force the Fed to allow its monetary policies to be audited by the Government Accountability Office (GAO). Since this time the Federal Reserve has responded by significantly increasing their balance sheet through their quantitative easing programs which began in early 2010.
Did the supposedly independent Fed succumb to political pressure? Did they initial easing programs in response to threats from congress? We may never have a clear cut answer but the data shows that since the proposed bills, the Fed has significantly increased their balance sheet. Note the graphic below. Never in history has such an increase occurred.
The motive for the Fed to ‘print’ such large amounts of money is to ease the debt burden and hopefully spur economic growth thru inflation. These actions have not only taken place in the US but around the world. If we just look at the US, Europe, England, Japan, and China, the central banks added over $300 billion of new assets in the first quarter of 2012, and $1.6 trillion over the last year.” Have central banks’ political independence around the world been compromised? Absolutely!
Political entities around the world know that they will quickly lose power if they let the global debt crisis get further out of control. They are putting pressure on central banks around the world to increase the money supply in order to monetize the debt and ease the heavy sovereign debt burdens put on the world by years of government deficit spending.
The question of further monetary easing by the Federal Reserve, China, and European Central banks appears to be a forgone conclusion. Political pressures continue to mount and money…not policy changes continue to be thrown at the situation in hopes of economic stability. Unfortunately the more money gets printed, the worse the inflation situation that Mr. Greenspan spoke of becomes. Rampant global inflation in the 20 years to come will put a great economic burden on our children all because prior generations deemed it best to spend uncontrollably in the name of economic growth. With the main political incentive being to print more money, the loss of the independence of Central banks around the world spells worsening problems for the global economy.
What does this mean for the markets? Volatility and lots of it. Without a stable monetary footing, markets will experience an increase in bubbles and bursts over the coming years. For aggressive individuals this spells opportunity but for those with a more traditional buy and hold mentality, inflation will eat at any potential gains in the coming years.