Growing anxiety that the world’s top central banks have lost control of their mission has intensified scrutiny of their mandates and independence from both political and investment circles.
Far from soothing already nervy financial markets, the US Federal Reserve’s decision not to raise interest rates in September raised more questions than it answered.
The turbulent response of equity, commodity and emerging markets marks this as a rare – if not singular – instance in recent years of markets reacting so negatively to an ostensibly dovish policy signal from the Fed.
Chief among the questions is whether the world’s most influential central bank, along with many of its peers, is trapped at near zero interest rates as the economic cycle crests and inflation flatlines, due to a rapid cooling of China and other emerging economies and a commodity price slump.
The uncomfortable prospect of heading into another economic slowdown with no interest rate ammunition to fight the downturn is at the root of much that investment angst.
“The relative paucity of the monetary policy toolkit increases the fragility of the expansion, with risks that an adverse shock could lead businesses and consumers to retrench and thereby transform a mid-cycle slowdown into something significantly worse,” wrote Citi chief economist Willem Buiter.
Yet by subsequently insisting a rate rise was still on the cards this year, the Fed simultaneously removed any low-rates balm and confused many as to its ‘reaction function’.
Just which of the global pressures that stayed its hand only two weeks ago – weakening China, emerging markets and commodity prices – will disappear again by year end?
And if the rise of the dollar is at least partly behind both those pressures and the below-target US inflation rate, then surely every future push to raise rates will simply strengthen the currency again and re-ignite the same chain reaction.
“You can’t run an independent, domestically-focused monetary policy in this environment,” said Salman Ahmed, chief strategist at asset managers Lombard Odier, adding that a major complication is the huge uncertainty internally at the Fed about just how the world’s second biggest economy, China, is actually performing.
“What has happened is that central banks have lost control to calibrate monetary policy to only domestic economic data.”
The Fed may be in the hot seat, but the Bank of England has a similar dilemma.
The Fed is itself in a peculiar bind
The Bank of Japan and European Central Bank differ only in that there’s no domestic pressure yet to tighten policy. But their attempts to avoid deep deflation and reach explicit inflation targets seem to be similarly sideswiped by global rather than domestic developments. And that’s not changing any time soon.
In a world that’s wound down very little of its overall indebtedness some seven years after the credit crash was supposed to launch a wave of ‘deleveraging’, relatively slow growth and over-reliance on cheap credit to cope with that funk has “zombified” global economies for years to come, Ahmed added.
And in such a low growth world, political pressure to bring central banks into a more centrally-directed policy framework will only increase.
The debate in Britain has shifted squarely in that direction already: the new left-wing leader of Britain’s main Opposition Labour Party, Jeremy Corbyn, and his finance spokesman, John McDonnell, are both long-standing critics of Bank of England independence.
McDonnell, who this week assembled a panel of advisers including Nobel laureate Joseph Stiglitz and French economist Thomas Piketty, advocates a ‘People’s QE’ where the BoE would be instructed to buy bonds sold by a new national development bank for infrastructure projects.
And one of those advisers, academic economist and former BoE policymaker David Blanchflower, said on Tuesday Labour was right to debate the bank’s mandate beyond pure inflation targeting.
“It should include new objectives for the monetary policy committee such as growth, employment and perhaps even earnings,” he wrote, adding the Fed’s model of seeking employment, stable prices and moderate long-term borrowing rates would be better.
But given the Fed is itself in a peculiar bind, that model may not impress some central bank critics.
And the concern among some economists and investors is that greater political control may leave the bank compromised in future to more extreme, short-term whims of parties in power.
British economist George Magnus said there may be a case for better coordination between government and central bank and some lines between the two had indeed blurred. But he warned of the danger of ‘crossing the Rubicon’ on central bank independence.
While countries like Japan with big surpluses may toy with that, he said, economies with large balance of payments gaps such as Britain may be more vulnerable to capital flight.
Former UK Financial Services Authority chief Adair Turner said this week that overt monetary financing of government spending may well have its place in a central bank’s remit. But fears that governments could overuse and abuse it meant it might need to be accompanied by even stricter laws protecting central bank integrity.