CENTRAL BANK INDEPENDENCE IS AS DEAD AS VAUDEVILLE / THE FINANCIAL TIMES OP EDITORIAL

Central bank independence is as dead as vaudeville

US and Europe queue for a rollercoaster ride as lessons of the past are forgotten

John Dizard 

President Richard Nixon with Milton Friedman to his right and Arthur Burns, chair of the Fed, to his left (AP)


Not to dwell on the past, but there was a time when central banks in advanced countries were supposed to be independent of their governments. That meant they were not expected to bend policy to meet the political requirements of the day or the election cycle.

There were times when the precept was violated. For example, it is generally believed that in 1971 Arthur Burns, then chair of the Federal Reserve, succumbed to pressure from the White House to imprudently loosen monetary policy to ensure a strong economy for Richard Nixon’s re-election. The economy boomed and Nixon won but the consequent inflation and damaged Fed credibility were not overcome until Paul Volcker’s Fed imposed high rates and a deep recession.

The Burns episode was seen for years as a historic mistake and a confirmation of why central bank independence is so critical for economic stability. Now that lesson is forgotten.

In the US and Europe, it would seem, central bank independence is as dead as vaudeville.

In the US, President Donald Trump’s nomination of Stephen Moore to the Federal Reserve is a shot across the Fed’s bow. The political and financial elite may think the White House is collectively stupid but Mr Trump and his advisers have recognised the political threat represented by the partially inverted yield curve. Inverted curves probably mean recession, which would mean no re-election.

That is a risk the White House cannot accept, whatever the blather about Fed independence and policy stability. Whether or not Mr Moore is formally nominated and then confirmed by the Senate, Mr Trump has made clear that he intends to get a cut in short-term policy rates from the Fed.

The president’s advisers may also consider pushing for a re-acceleration in the Fed’s process of unwinding its bond book. After all, if a steeper yield curve means a stronger economy, why not push on both ends?

Most economists, and, for that matter, corporate America, think the US is already pushing the bounds of non-inflationary growth. Labour shortages are endemic, shipments are late, profit margins are under pressure, consumers grow more cautious.

Time to pull back and wind in — unless you need one more year of euphoria to ensure you stay in office.

Then you might be willing to settle for inflationary growth, even if it comes with future instability. True, your trading partners may think you are engaging in a competitive devaluation and irresponsible behaviour, but you probably do not care about their opinion. As Mr Trump says, what have they done for us?

Of course this brings back memories of 1971-72, Nixon’s landslide re-election and the decade-long hangover. We even have a set of bubbling White House scandals. Why not put off the day of reckoning for a year or two, if at all possible?

If we do not get this sort of policy bouleversement out of the White House and the Fed, then we could find out how all those post-crisis reforms in the financial system will work when the pressure is on.

For example, if there were to be a bear market in equity, we are likely to see a considerable amount of BBB corporate debt pushed below investment grade by the rating agencies. Just part of the normal economic cycle.

Except that the concentration of corporate paper teetering on the BBB bubble is historically large. Much of it has been pledged to the banking system for what is called “collateral transformation” in repo transactions. The banks provide high quality liquid assets to use as collateral for derivative transactions, which are run through those central clearing houses that were going to eliminate the risk of “another Lehman”.

In the event of ratings downgrades and greater market volatility, the banks will impose deeper haircuts in return for meeting the consequent higher margin calls.

This is the sort of mechanism that feeds on itself. If you are a White House economic adviser, do you want to be at weekend after weekend of crisis meetings dealing with that problem? Or would you prefer to be at the post-election victory parties?

Well, life in America has always been something of a rollercoaster ride. Unfortunately, there is also considerable pressure in Europe. There is another interesting drama playing out between the European Central Bank and its member countries over who gets to supervise clearing houses. This has been well reported in this newspaper but mostly ignored by European political commentators.

The critical faultline in Europe could well run through the clearing houses. The ECB has long believed that it should be in charge of crisis management should there be an issue with the orderly functioning of clearing and settlement systems. The national regulators (and governments) believe it should be part of their competence.

European markets would be short of good collateral to meet margin calls in a crisis. Control over the ECB’s vast balance sheet might then shift to the national governments. So much for its independence.