Central Banks’ Prized Independence May Be a Hindrance in Managing Inflation

Advocates of policy cooperation with governments say risk of political influence is exaggerated

By Tom Fairless

FRANKFURT—In their battle against high inflation, governments granted significant independence to central banks over recent decades.

Now, some economists argue that same independence could be hampering their ability to combat the current era’s problem: inflation that’s too low.

To safeguard their independence, major central banks may have deployed “second-best” policies that distort financial markets and face diminishing returns, such as negative interest rates and large-scale bond purchases, and shunned potentially more effective tools such as “helicopter money,” argues Joachim Fels, global economic adviser at Pimco.

Helicopter money, which could involve, for example, an increase in public spending or tax cuts financed by the central bank, takes central banks beyond their traditional realm of influencing the price and volume of credit to determining how public money is spent—the domain of elected politicians.

Bank of Japan Gov. Haruhiko Kuroda has warned repeatedly that helicopter money would be an unacceptable intermingling of fiscal and monetary policy. In July, the BOJ disappointed hopes that it might embark on an experiment with helicopter money.

In Europe, Bundesbank President Jens Weidmann has cited similar concerns over the independence of the European Central Bank as a reason not to deploy helicopter money. ECB President Mario Draghi says that the topic hasn’t even been discussed at policy meetings.

The fear is that if governments started to finance their deficits through the money-printing presses, they would succumb to politicians’ desire to spend without raising taxes. The result would, eventually, be higher inflation.

“To be told to increase the balance sheet by x would mean the independence was lost, and the effects on inflationary expectations could be quite dramatic,” said Charles Goodhart, a former member of the Bank of England’s monetary policy committee.

Yet advocates of more cooperation say such risks are exaggerated relative to the benefits that closer cooperation could achieve in today’s circumstances.

During World War II, the Federal Reserve helped finance the U.S. war effort by ensuring that long-term interest rates remained at 2.5%, whatever the size of the fiscal deficit. When that policy ended in 1951, the Fed didn’t reverse its purchases, so that “post facto, a significant proportion of U.S. fiscal deficits from the early 1940s to 1951 was money-financed,” said former British financial regulator Adair Turner in a 2013 lecture.

All that government spending was accompanied by a huge rise in inflation-adjusted economic output, although it also created huge pent-up inflation pressure that erupted once wage and price controls were lifted. Prices shot up 34% between 1945 and 1948, but then inflation reverted to low single digits.

Once the cap on Treasury yields was removed, the Fed “effectively became more independent,” said Alex Cukierman, a member of the Bank of Israel’s Monetary Committee.

In practice, there may be little difference between helicopter money and current policies like quantitative easing, which cover a large swath of current government deficits.

Policies adopted during the recent crisis have also been “subject to a high level of discussion between central banks and governments,” said Mr. Goodhart. “Helicopters have already been flying in huge formations in Japan.”

Most important, today’s circumstances are very different from the past: With interest rates at zero or even negative, central banks simply can’t boost spending or inflation much more by themselves. Mr. Draghi has called, with increasing urgency, for help from other policy makers, including elected officials.

At a news conference Thursday, Mr. Draghi made an unusually direct plea to Germany to spend more to boost the region’s economy.

Asked about helicopter money in June, Fed Chairwoman Janet Yellen said that, in unusual times when the concern is very weak growth or possibly deflation, fiscal and monetary authorities should “not be working at cross-purposes…—but together.”

“Now, whether or not in such extreme circumstances, there might be a case for, let’s say, coordination—close coordination, with the central bank playing a role in financing fiscal policy; this is something that…one might legitimately consider,” Ms. Yellen said.

The difficulty is in finding the right mechanism. Former Fed Chairman Ben Bernanke proposed in April that the Fed could credit a special Treasury account with funds if it assessed such a stimulus was needed to achieve its employment and inflation goals. The U.S. government would then determine how to spend the funds, or could leave them unspent.

In the eurozone, cooperation is complicated by the need for 19 governments to agree among themselves first. One partial solution, suggests Mr. Cukierman, may be to alter the ECB’s charter to focus less on inflation and more on economic activity, like the Fed.

Another possibility: put the onus on governments instead of the ECB. Princeton University economics professor Christopher Sims suggests a eurozone-wide moratorium on the bloc’s debt limits, “to be kept in place until areawide inflation reaches and sustains the target level.”

Greater cooperation with governments would help address another criticism: Central banks are increasingly making decisions that affect the distribution of wealth and income, decisions that belong in the hands of democratically elected governments.

Athanasios Orphanides, a former ECB policy maker, points to the Fed’s decision to support the U.S. housing sector by purchasing large quantities of mortgage-backed debt, and the ECB’s “uneven” support for different eurozone governments.

Thus, if central banks can’t avoid politically controversial actions, the question is how to maximize the benefits of such actions. That might, ironically, involve less independence, not more. 

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