Jerome Powell was a few months into his job as the Chair of the Federal Reserve when
U.S. President Donald Trump complained about the central bank’s policies.
“I put a very good man in the Fed.
I don't necessarily agree with it, because he is raising interest rates.”
He’s not the only one complaining.
Italy, India, Turkey and Argentina are just a few of the countries seeing leaders push
back against central bank independence - and some are succeeding.
In the last few years, we’ve seen central bankers get fired,
resign and have their decisions and motivations questioned.
That's led to a number of voices declaring
that the independence of these public institutions is under threat.
But why do we even care whether central banks are independent or not?
It’s kind of a long story.
Let’s go back almost a hundred years for some context.
After the First World War, Germany was in a lot of debt and its costs were racking up.
Soldiers needed pensions.
War widows needed compensation.
France and Great Britain were demanding massive reparations.
And other countries did not want to lend Germany any money.
So Germany’s central bank printed more and more money and loaned it to the government,
hoping to make up the difference.
What they ended up with instead was hyperinflation.
All that cash caused prices to skyrocket.
At the height of the crisis, hyperinflation reached rates of more than 30,000% per month,
meaning prices were doubling every few days.
That’s why in some historical photos, you’ll see Germans burning cash to keep warm
because it was cheaper than buying wood.
This – and more recent examples like the hyperinflations in Zimbabwe and Venezuela – has
shown us the damage out of control inflation can to do an economy and its people.
So when the Bundesbank became Germany’s central bank in 1957, its laser focus on a
stable currency and keeping out of control inflation at bay were no surprise.
It was the first central bank to be given full independence, and it quickly gained
the reputation of being the world’s most independent and conservative central bank.
At the same time, the Bank of England and most of its European counterparts were still
controlled by their governments. Let’s get into why that matters.
Throughout the 1960s, most policymakers believed you could permanently lower unemployment by
accepting higher inflation. This economic concept is known as the Phillips Curve.
So conventional wisdom was that the central banks could increase the money supply, inflation
would go up a bit, and more people would have jobs.
It sounds great, right?
Politicians loved this idea too.
After all, a low unemployment rate is helpful when you’re trying to get reelected.
Take former U.S. President Richard Nixon.
He inherited a recession when he was inaugurated in 1969.
"Our destiny offers not the cup of despair, but the chalice of opportunity."
And when it came time to getting reelected he was focused on keeping the economy moving.
The best way to do that, he thought, was to lower interest rates.
"A lot of the people are going to say, well here we go back into high interest rates again..."
...I don't think that's a justified assumption."
Behind closed doors, he pressured the Federal Reserve Chairman to do just that,
and even though the Fed is supposed to be independent from the government,
the central banker appeared to comply.
The economy got its boost, and Nixon was reelected.
But he got a rude awakening not too long after that. Enter the Great Inflation, the first prolonged,
major period of inflation the world had seen during peacetime.
Annual inflation rates reached levels of over 10 percent across OECD countries, and some
people began to panic. What’s worse?
The Phillips curve didn’t hold true over the long term.
Inflation was high and so was unemployment.
It was lose-lose, a phenomenon known as stagflation.
Many people pointed to the 1970s energy crisis as the culprit, which caused the price of petrol to skyrocket.
"Gasoline stations ran dry. Airlines cut back flight schedules. Factories were forced to close."
But the general consensus today is that the monetary policy of the time played a significant
role as well. Just take a look at this chart.
You can see the inflation rates in the U.S., U.K., Italy and Japan spiking during the Great Inflation.
But Germany, home to the Bundesbank, kept inflation at a much more modest level.
So did Switzerland, which also had a very independent central bank.
The 1970s exposed flaws in having governments controlling central banks.
The nature of election cycles means politicians have an inherent conflict of interest when
making decisions that impact the economy.
"As the recovery gathers pace, so our political fortunes will continue to improve."
It’s tempting for them to skip unpopular choices like raising interest rates
or cutting the budget deficit in an election year.
So during the 1980s and 1990s, many central banks,
including the Bank of England, were granted independence.
The European Central Bank was established in 1998, and was modeled on the Bundesbank,
meaning it was independent from the outset.
The system had changed.
Politicians still set the broad goal – keep prices stable.
But it was up to the central bankers to make it happen.
"I want an end to the stop-go, the boom-bust economics of the past."
Billions of people around the world got used to low and stable inflation and the security
of knowing the interest rates on their bank deposits and mortgages were under control.
"Interest rates have come down. Inflation is down."
But then the financial crisis happened...
"But will these moves by central banks solve the problem?"
...pushing central banks into the spotlight.
They announced emergency measures and unconventional steps to prop up the economy.
Essentially central banks became 'crisis response units' trying to stop the next Great Depression.
"The ECB is ready to do whatever it takes to preserve the euro."
Some people began to question whether the institutions really had their best interests at heart.
Protesters complained central banks were too secretive and that they cared more about bailing
out big banks than helping everyday people.
And of course, there was failing to spot the financial crisis in the first place.
Even though central bank independence was put in place to stop inflation from going
too high, some point out that a decade after the crisis, the actual challenge is inflation
rates being too low. So is their mandate still relevant?
It’s a question many are trying to answer, including some central banks themselves.
But however they evolve, central bank bosses argue trust is key for them to be effective.
And to be trusted, they have to be independent.
"Without independence, policy is bound to go astray."
Yet it’s not that easy.
Despite their supposed independence, most central bank heads are appointed by a political process.
For example, the European Council picks the ECB head
and the U.S. President selects the Fed boss.
"There are few more important positions than this."
In extreme situations, governments fire central bankers too.
Take Turkey.
Its president Recep Tayyip Erdogan fired his central bank chief in July 2019.
Many speculate this was due to his unwillingness to lower interest rates at Erdogan’s request.
Research has consistently shown that economies perform better and prices are more stable
when central banks are independent. But with populist leaders in power and interest
rates at historic lows, whether central bankers will be able to hold on to the autonomy they‘ve
enjoyed for the last generation remains to be seen.