Hawks & Doves | The rationale of Central Banks independence

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di Lorenzo Sala

In recent weeks, on both sides of the Atlantic central banks have been attacked by politicians. Professor Donato Masciandaro explains the reason why central banks independence is fundamental in order to struggle against the tendency of financial markets to create bubbles and to grant the credibility of monetary policy.

October has been the worse month for Wall Street since 2009: Trump has blamed FED monetary policy for this, what do you comment about it?

“This attack stresses the importance of central banks’ independence. We have to distinguish between the traditional meaning of central bank independence before the crisis and today’s and future meaning. Before the crisis the idea was that, in order to have credible and effective monetary policies, the monetary player must be credible. Governments cannot be credible monetary players since leading policy making they are tempted to bend monetary policy to address other macroeconomic problems, such as unemployment, fiscal deficits or banks crisis. In such cases, the more the market is efficient, the more negative will be the final outcome. Governments tend to implement cheating monetary policies: they announce a policy and then do the opposite. For example, during the ‘70s governments had the incentive to announce restrictive monetary policies and then implement expansionary monetary policies in order to build up an inflation surprise, which implies real wages lower than expected and potentially higher employment. But the more cheating policies are implemented, the more market and player incorporate government’s cheating incentives in their expectations. At the end of the game there will be no real effect of cheating apart from inflation. This is what happened between the ‘70s and the ‘80s. Finally, politicians realized they were not any more credible monetary players. At a certain point they needed anti-inflationary monetary policies and were forced to separate central banks action from government’s control. Independent central bankers are bureaucrats with no incentive to cheat, since they are not required to increase employment or to please the voters. They are nominated, and their career depends on their reputation, that is linked to the central bank reputation. Thus, at the end of past century in many advanced countries, and not only, were created independent central banks.”

What is the situation today?

“Today there is not any more a problem of high inflation, but we still need independent central banks. The reason lies in the incentive that still politicians have to use monetary policy to pursue short-term goals leading to bubbles. Inflation, for instance, is a bubble in consumer prices. During the Great Moderation we didn’t have inflation problems, but financial bubbles and house market bubbles.

Governments can criticize central bank policy if it is not transparent. Indeed, central bank independence means that central bank must tell what are the goals, which are the tools to achieve them and their consistency, it doesn’t mean discretion. To be concrete, President Trump can criticize FED action because it is not transparent: it has two targets, inflation and employment, but we know the former (2%), while we don’t know the latter. There is not only a lack of transparency in terms of goals but also in terms of tools: we don’t know what it is its forward guidance. Indeed, it doesn’t have an institutional commitment, but it uses the dot plot, anonymous individual provisions of the board’s members. Moreover, there cannot be a reaction function since FED doesn’t tell what its neutral interest rate is (the interest rate according to which monetary policy would be neither expansionary nor restrictive).

To sum up, President Trump can criticize FED, but he cannot attack its independence because this would result in a loss of credibility of monetary policy. A similar conflict is occurring in India, where the government is blaming the central bank for too harsh monetary policy. Not by chance, Trump attacked the FED few days before midterm elections and within six months there will be elections in India. Conflict between politicians looking for consensus and central banks implementing policies not consistent with politicians’ goals is a never-ending story. Depending on the country and the phase of the economic cycle, we can have different outcomes.”

Meanwhile Draghi in his press conference has announced, as expected, the end of QE in December. What will the ECB do with government bonds in its balance sheet? To what extent will monetary policy change?

“In terms of monetary policy stance, Draghi has confirmed that the QE is tapering and that if there is not any particular macroeconomic news it will end by December 2018. However, Mario Draghi has stressed that monetary policy will remain expansionary, mainly for three reasons. First, there will be no more new purchases of bonds and securities on financial markets, but there will be reinvestment of bonds arriving to maturity, meaning that the monetary base will not decrease. Secondly, interest rates will remain low up to the end of next summer. Third, the forward guidance policy and the commitment begun with the famous “whatever it takes” will still be active.

The second significant topic of Mario Draghi’s press conference was about the rules of the game. He recalled what the ECB cannot do. First of all, it cannot accommodate fiscal imbalances. The Treaty is clear: the main goal of the ECB is monetary stability. Secondly, also the implementation of the monetary policy operations is very clear. For example, there are clear rules in order to avoid any kind of fiscal accommodation through the action of the ECB on foreign exchange market.

It was very important that Draghi highlighted the distinction between monetary policy normalization and the need of fiscal accommodation of high debt countries. Moreover, he stressed that, although since November 2014 banking supervision and monetary policy both pertain to ECB domain, they are part of separate policies. Also, from an institutional point of view there is a separation between the Board of Governors and the Supervisory Board, with an exchange of information taking place, but different responsibilities. Thus, if there is a banking problem in one member country it is not a matter of monetary policy, but of national authorities and supranational supervision.”