Twin threats to central bank independence

  • Central banks enjoy a reputation of, if not omniscient omnipotence, at least competence
  • The current bout of inflation has shown that the omniscient omnipotence is absent
  • It also risk showing a lack of competence, if they do too much – or too little

Central banks have long enjoyed a high reputation in the public policy domain. Sometimes exaggeratedly so, as in the case of Alan Greenspan, who was almost believed to be not only omniscient, but omnipotent as well. But even other central bankers were generally credited with two important attributes. First, being independent, they could be trusted to not make decisions based on short-term political expedience. Second, they were competent at their job (and often believed to be competent at other tasks as well).

The reputation for (near) omniscient omnipotence will have been permanently lost after the more than ten years during which central bankers were unable to achieve their inflation targets. True, this was from below, which is at least better than having the same problem from above, but it was still a failure.

However, central bankers are now also at risk of losing their reputation for competence. Over the past two years, all major western central banks initially played down the danger of inflation. When inflation began to accelerate, they went to great lengths to claim that it was limited, and ‘transitory’, and therefore need not be acted upon. They were wrong and have been scrambling to catch up for most of this year.

In essence, they now face two dangers. One (this is mainly the Federal Reserve and possibly the Bank of England situation) is doing too much. Mindful of their previous complacency, they will push ahead with too large interest rate increases that risk plunging their economies into recession.

The second danger (mainly faced by the ECB), is to not do enough. Christine Lagarde, the President of the ECB, has said that she expects the Bank to exit negative interest rates by September. That would be after eleven months of above-target inflation. The risk here is that the ECB will allow inflation to become entrenched.

Why these dangers? Because the bout of inflation so many countries are currently experiencing is monetary in origin, a consequence of the explosive growth in money supply during the first two years of the pandemic.

But this year, there have been two key developments that affect the future of inflation. The first is that money supply growth is slowing sharply. In the US broad money growth spent much of the two years from December 2019 to November 2021 in the double digits. The latest number, April 2022, is 6.7% and on a three-month annualised basis it was 2%. UK M4x growth has been between 5% and 6% for three months; and in the euro area, M3 growth dropped to 6.3% in the year to March, 5.1% on a three-month annualised basis. These numbers are perfectly consistent with medium-term output growth at trend and inflation around 2%, implying that, left to itself, inflation would accelerate further during the remainder of 2022, but then begin to slow, possibly quite quite rapidly, in 2023 and 2024. 

However, there is then the second development, which is of course the consequences of the war in Ukraine, notably on commodity prices. This is a non-monetary shock. Crucially, this means that it is most likely a once-off. It is often believed non-monetary shocks cannot be countered by monetary policy, but this is wrong. Central banks can still either validate inflation – by doing nothing – or attempt to negate it – by tightening monetary policy.

The best way to deal with this situation would be for central banks to tighten monetary policy, but not too far. The situation is complicated by the fact that most central banks neither understand, nor ascribe any importance to money. Hence, the Fed/Bank of England risk is that the ongoing debate on the cost-of-living crisis will push them into tightening policy far too much, goaded by media and politicians who accuse them (rightly) of having been behind the curve and (probably wrongly) of remaining there. The ECB risk, by contrast, is that by doing nothing, faith in the central bank’s ability to dampen inflation will erode and a wage-price spiral will develop, causing inflation to become entrenched.

Either way, this risks further undermining central banks’ reputation for competence. And if that reputation goes, the question will soon arise, why have independent central banks at all? Why let unelected technocrats decide something as important as monetary policy?

And so the issue right now becomes as much how to deal with inflation as about the future of central banks. If central bankers can maintain confidence in their ability to control or at least mitigate inflation, then they are likely to be able to retain their independence (even if their focus may well shift). If, per contra, they fail, either by doing too much or too little, the calls to strip them of their independence and subordinate them to the will of the people (i.e., of politicians) will grow.

That would be unfortunate. Central banks and central bankers are certainly neither omnipotent, nor omniscient, and they make mistakes. But the key argument for the independence of central banks – to repeat, the ability to concentrate on one task and to take a longer view, unencumbered by short-term political considerations dictated by the election cycle – remains as valid as ever.