Though central banking has been around for centuries, the power and influence of central banks have waxed and waned over the years. From their unassailable role as guardians of the gold standard in the nineteenth century, central banks fell into relative impotence during the Bretton Woods system of stable exchange rates in the 1950s and 1960s, which effectively put monetary policy on autopilot. And while they regained agency with the move to flexible exchange rates, the credibility of most central banks was tarnished by their failure to control inflation in the 1970s.
In the last 30 years or so, however, central banks have regained the high ground they held a century ago, when Montagu Norman, the legendary governor of the Bank of England, articulated his view that a central banker should “never explain, never apologize.” This ascent reflects the success of central banks in the industrial countries in first reducing inflation and then keeping inflation low since the 1990s.
Not coincidentally, the renaissance of central banking coincides with an important innovation in governance arrangements. As inflation crept progressively higher through the 1970s, and economic performance in the advanced economies steadily worsened, central banks abandoned their efforts to control inflation by constraining the growth of the money supply.
From Monetary Targets to Inflation Targeting
In place of targeting monetary aggregates, most central banks around the globe started targeting inflation directly. They do so by controlling short-term interest rates, raising rates in the face of inflationary pressures and lowering rates when the economy slows and price pressures ebb. But if central banks were to take direct responsibility for controlling inflation, it was clear that they would need some degree of autonomy. Otherwise, monetary policy could be used to advance political priorities rather than the fundamental goal of price stability. The case for independence was made by William McChesney Martin, chairman of the US Federal Reserve in the 1950s and 1960s, who remarked facetiously that the job of the Federal Reserve is to order “the punch bowl removed just as the party was really warming up.” In this respect, central bank independence is a core element of inflation targeting.
In many countries around the globe, that independence is under attack. Most of these cases reflect the efforts of authoritarian governments and populist leaders to use monetary policy for their own political or personal purposes; none is more worrisome than US President Donald Trump’s efforts to browbeat Jerome Powell, chairman of the Federal Reserve, into lowering interest rates. Since returning to the White House one year ago, Trump has consistently denigrated Powell in the misguided belief that name calling and intimidation will bring about a change in the Fed’s policy.
Throughout it all, Powell has maintained his composure, thoughtfully and calmly explaining why the Fed hasn’t bent to Trump’s will and cut interest rates more aggressively. That stubbornness and commitment to duty undoubtedly grates on the president, who, seeing his dismal polling numbers, may want to run the economy “hot” in the months leading up to the November midterm elections. If implemented, such a strategy would risk overheating the economy, leading to macroeconomic imbalances and unleashing inflationary pressures. Inevitably, such a scenario would end with the Fed having to tighten monetary policy, inducing a recession, to bring inflation down and keep inflation expectations anchored.
That scenario would be bad enough. But it could be worse, with far-reaching consequences for the global economy. This is because the US dollar performs a unique role in global finance. That role reflects several factors, including the privileged position accorded to it in the Bretton Woods system as the anchor currency for international finance. Today, the dollar continues to serve as the dominant international medium of exchange, unit of account and store of value. It retains these roles because international investors believe that the Fed will act to preserve price stability — to protect the value of the dollar against the corrosive effects of inflation. That belief could be discarded if the Fed is no longer seen as independent of the White House.
Such a revision in beliefs may already be reflected in the so-called “debasement trade,” which entails the sale of US dollar assets by foreign investors, that has emerged following Trump’s reckless “liberation day” tariffs last year. If the adjustments in the value of the dollar and global portfolios are gradual and orderly, the risks to the global economy may be contained. However, a sudden, disorderly adjustment of international portfolios and a rapid realignment of the dollar against other currencies could trigger severe financial dislocation from the revaluation of corporate, household and government balance sheets around the globe.
And while some risk can be hedged, the sudden repricing of asset values invariably creates losses. If those losses are concentrated in banks and other financial institutions, the contraction of their balance sheets could trigger the kind of domino-like effects that swept through global financial markets in the autumn of 2008.
Attacks on the Fed’s independence thus pose a potentially grave threat not just to the United States but also to the global economy.
The fear of such effects may account for the relief with which financial markets greeted Trump’s nomination of Kevin Warsh to succeed Powell, whose term as Fed chairman ends in April. On paper, Warsh appears to be a sound choice for the job, with strong anti-inflation credentials. Markets may believe that Warsh will stand up to Trump’s demands for more expansionary monetary easing, or that the president will stop his attacks on the Fed’s independence once his nominee is in place. Perhaps that will be the case. It seems far more likely, however, that Trump only appointed Warsh with the expectation that the new Fed chairman will acquiesce to demands for easy money. In other words, that Warsh won’t take away the punch bowl.
A more permissive regulatory environment would finance the “hot” economy that Trump wants before the midterms. Unfortunately, lower capital and liquidity buffers would increase the risk of financial crises.
On this score, Warsh’s previous views on monetary policy seem to have been conditioned on the political affiliation of the person occupying the White House or the party controlling Congress: hawkish on inflation when the Democrats are in control; dovish when Republicans are in charge. That “flexibility” certainly doesn’t augur well, given the challenging environment the Fed is likely to face over the coming year or so. And even if Trump refrains from publicly pressuring “his” Fed chair, the fact that Trump’s justice department initiated a spurious criminal investigation into Powell will surely weigh on Warsh, who knows that he, too, could be subject to such intimidation.
Deregulation and Unelected Power
But even if Warsh resists Trump’s blandishments to reduce interest rates, or he is blocked by the other members of the Fed’s interest rate-setting committee, there is another way in which the president can exert his will. The Fed plays a critical role in safeguarding financial stability by regulating the biggest banks in the United States. If Trump can’t lower interest rates, he can pressure Warsh to relax regulations introduced in the wake of the global financial crisis.
Citing the need to constrain unelected power, Warsh has expressed support for deregulation, a key priority of Trump’s, and one that could be pursued outside the public scrutiny given to interest rate decisions. Deregulation would undoubtedly find support among banks and other financial institutions subject to the Fed’s rulemaking, for whom less regulation is always preferred to more regulation.
A more permissive regulatory environment would finance the “hot” economy that Trump wants before the midterms. Unfortunately, lower capital and liquidity buffers would increase the risk of financial crises. In this regard, just as central bank independence is critical to achieving better outcomes in terms of low inflation and stable growth, bank regulation reduces the risk of financial crisis or limits the size of those that do occur.
It bears noting that the global financial crisis, which brought the international financial system to the brink of a catastrophic meltdown in 2008, was preceded by deregulation that facilitated the explosive growth of securitized assets, including the subprime mortgage securities at the epicentre of the crisis. The social dislocation that resulted from the global financial crisis widened the social cleavages that have, arguably, fuelled populist politicians and led to the rise of authoritarian governments around the globe.
The point in all this is that democratic societies must balance central bank independence against the benefits of low, stable inflation and financial stability. And while inflation-targeting central banks currently have considerable “unelected” power, it is not Norman’s “never explain, never apologize” approach. Rather, it is a system of constrained discretion under which the central bank has the operational independence to achieve its inflation targets but is accountable to the elected legislature. It is, fundamentally, a far-sighted approach that aims to achieve long-term goals. In contrast, Trump’s attempts to erode the independence of the Fed reveals a shortsighted approach — one that is fundamentally inconsistent with the norms that have safeguarded American prosperity for the past century.
