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Friday, August 31, 2007

Central Bank Independence in the US and other Countries

Willem Buiter says "the US has become one of the least operationally independent of the central banks in the industrial world":

A Fed Chairman's lot is not a happy one (happy one), by Willem Buiter: Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee ... and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures...

[T]he fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. ...

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the ... goals of monetary policy. ... Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out. ...

Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. ... Credit crunches and liquidity crises therefore matter only to the extent that they affect these ... goals, now or in the future. Fortunately, instruments exist with which credit squeezes and liquidity crises can be addressed effectively, and without creating moral hazard (such as the MMLR at punitive prices described above) that do not involve changing the monetary policy rate.

I hope and expect that if and when the Fed perceives that real economic activity is likely to weaken materially going forward and/or that inflation is likely to undershoot its comfort zone ..., rates will be cut decisively and without delay.

I also fear and expect that, because of the relentless pressure being brought to bear on the Fed by all branches of the Federal Government (with the exception, as far as I know, of the Supreme Court), the Fed will be convinced to cut the Federal Funds target rate, probably as soon as the September meeting. I fear this could be not because this is the best way to guarantee the optimal trade-off between its three macroeconomic goals, but because this is the only way to salvage some measure of future independence for the Fed, in the face of irresistible pressure for a cut now from a lobby for a lower Federal Funds rate that includes special interests ranging from low income households unable to service their wildly inappropriate mortgages to extremely high net worth hedge fund managers facing massive losses and early retirement.

I hope I’m wrong on the last point.

Just one comment. In the US, the intent is not for the Fed to be completely politically independent, there are mechansims in place that allow various political interests be represented in the deliberations over monetary policy. Though power has been centralized over time so that some of these mechansims are now relatively weak, the set up of the system tries to ensure that banking, business, and the public interests are repersented on the monetary policy committee, that power is distributed geographically, and the structure is such that the executive branch has political influence over the chair of the Fed (e.g. four year terms). Whether or not this is the best way to set up the central bank is something to consider - I favor more independence than we have now - but the fact that there is political influence and representation is not at odds with the design of the Federal Reserve system.

    Posted by on Friday, August 31, 2007 at 12:15 AM in Economics, Monetary Policy, Politics | Permalink  TrackBack (0)  Comments (13)


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