Central banks risk losing their precious independence

Bloomberg

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The global financial crisis is forcing the world’s central bankers to surrender some of their prized independence. Regaining it won’t be easy.

More than a principle is at stake. For longer than a quarter-century, independent central banks have been able to take painful and politically unpopular measures needed to restrain inflation. But the worst economic calamity since the 1930s has left Ben S. Bernanke, Mervyn King, Masaaki Shirakawa and their colleagues little choice but to align their institutions’ policies with those of their nations’ elected leaders.

As a result, policy makers may find it harder to act whenever the time finally comes to begin soaking up the money with which they have flooded the globe.

"The lines between central banks and governments are becoming fuzzier," says Nouriel Roubini, a New York University economist. "Inflation is the path of least resistance for politicians, but it is dangerous."

Finance ministers and central bankers from the Group of Seven nations will discuss what more they can do together when they meet Feb. 14 in Rome. What’s brought them to this point is the collapse of credit markets, which has robbed traditional monetary policy of much of its punch.

The U.S. risks a deflationary economic decline - in which output, prices and wages all fall - even after repeated interest-rate cuts that have driven the overnight bank lending rate close to zero. In response, Federal Reserve Chairman Bernanke has joined with the U.S. Treasury in unprecedented steps to revive credit.

Buying up securities

Meanwhile, King and Shirakawa, his British and Japanese counterparts, are set to start on the same course after seeking a go-ahead from their governments to buy up private-sector securities.

"Monetary authorities and the fiscal authorities are working hand-in-glove," Canadian Finance Minister Jim Flaherty said in an interview.

While that may be necessary now, it could turn into a problem later. Some Fed policy makers have already stressed the need to move quickly, once the crisis passes, to sop up all the money they have pumped into the financial system.

Treasury Secretary Timothy Geithner has voiced the opposite concern, noting that Japan in the 1990s and the U.S. in the 1930s snuffed out incipient recoveries by prematurely tightening credit. He has vowed not to repeat that mistake.

The Treasury is providing seed capital for many of the credit facilities the central bank will ultimately have to unwind - including $20 billion to cover any initial losses on the Fed’s planned $200 billion program to promote loans to students, small businesses and auto buyers.

What’s more, the Treasury may end up playing a greater role in helping the Fed soak up the hundreds of billions of dollars of liquidity it has pushed into the financial system. That’s because of changes in the size and makeup of the Fed’s balance sheet.

In the past, the Fed has withdrawn money from the market by selling Treasury debt it holds to private investors. Those holdings have now dwindled, even as the balance sheet has ballooned, because the central bank has been swapping its Treasuries for riskier, harder-to-sell assets in an effort to revive the credit markets.

That means the Fed may need to rely on the Treasury to sell bills on its behalf when it wants to withdraw money from the economy.

Bernanke plays down the difficulty. "A significant shrinking of the balance sheet can be accomplished relatively quickly," he said in a Jan. 13 speech, in part because many assets the Fed holds are short-term and thus can be retired routinely as they come due.

Some of Bernanke’s colleagues fret that the Fed has also opened itself up to political interference by allocating credit to certain sectors of the economy according to the types of securities it purchases. Stanford University Professor John Taylor dubs that strategy "mondustrial" policy - a hybrid of monetary and industrial policy. In response to comments Taylor made during a Jan. 3 panel discussion in San Francisco, Federal Reserve Bank of St. Louis President James Bullard said he’s "very concerned" about maintaining independence.

The Fed isn’t alone in radically remaking the way it does business. With its benchmark rate now at a record low of 1 percent, the Bank of England is undergoing the biggest changes to its monetary-policy framework since it won control over interest rates in 1997.

The British government last month granted King, the bank’s governor, authority to spend 50 billion pounds ($73 billion) on bonds and commercial paper as a way of unfreezing markets. The Debt Management Office will sell Treasury bills to pay for the purchases.

To use the fund for stimulating the economy by boosting the money supply, the central bank will first need permission from Chancellor of the Exchequer Alistair Darling.

"This is something that could only be done with the Treasury and the Bank of England working hand in hand," Darling said last month. Thomas Mayer, chief European economist at Deutsche Bank, says the Bank of England may struggle more than the Fed to reassert itself, given that it has been independent for only 12 years.

In Japan, central-bank governor Shirakawa cut interest rates in December after the government lobbied the Bank of Japan to spur economic growth. He has now asked the government for approval to buy up to 1 trillion yen ($11 billion) of shares owned by financial institutions.