The fallacy of CB independence
Central banks are no longer independent of politics, argues Kommer van Trigt, and investors should take that into account
Central banks operate independently of politics. That’s the theory. There should be a strict dividing line between bank and state that prevents politicians from printing money to curry favour with voters. But that is not the case.
The financial crisis has shown the independence of monetary authorities to be a sham. No more than you can disconnect the water levels in the Thames from the tides in the North Sea, can central banks’ crisis measures be separated from politics.
Consider Mario Draghi, president of the European Central Bank (ECB). He regularly discusses monetary policy with European politicians. The ECB’s commitment to buy up unlimited amounts of government bonds probably came about only after discussions with the German chancellor, Angela Merkel.
Prior to the introduction of outright monetary transactions (OMT), the Frankfurt-based central bank had offered its services to politicians more than once. Italy, Spain and Portugal, for instance, have been paying lower interest thanks to the ECB’s intervention in bond markets. The result is the ECB is stuck with mounds of debt – it holds no less than 5% of outstanding Italian sovereign debt.
The euro area is not an exception. The US Federal Reserve and the Bank of England are helping those in power. The Fed buys $45bn (€34.7bn) of Treasuries every month, and now possesses some 15% of US debt, while the Bank of England has as much as 30% of UK public debt on its books.
The president of the Bank of Japan, Haruhiko Kuroda, has obeyed prime minister Shinzo Abe in buying government bonds to kick-start the economy. Kuroda really is pulling out all the stops. He is buying almost as much value in JGBs as Ben Bernanke, his American equivalent, purchases every month, while his economy is three times smaller.
Is it really that bad that central banks are subject to greater political influence? In the near term, there is no reason to sound the alarm. On the contrary, the monetary authorities’ unconventional measures have calmed the financial markets.
But the hangover follows shortly after the party.
Currently, the interests of central bankers and politicians are in unison, as both want to
prevent the crisis from escalating. But their aims are likely to fall out of sync when the central banks want to stop buying debt. This conflict of interest could lead to inflation.
Politicians are becoming addicted to low interest rates, as it means that they pay less for debt. What’s more, they are benefiting from positive side-effects from the bond-buying operations – the profits booked by central banks thanks to the interest income received on the bonds they have purchased.
Governments are creaming off the profits – after all, it’s free money for them. According to Morgan Stanley, central banks are collecting profits of some $140bn annually on the debt they have purchased. That’s a nice gift in financially difficult times.
As with every side-effect, this will stop once the medicine is no longer taken. When a central bank increases interest rates, the profits from its intervention activities will dry up. Politicians are therefore tending to discourage their central banks from interest-rate hikes that would cause a direct shortfall in their own budgets. In the UK, a discussion has already arisen about whether the BoE should not just write off the Gilts on its balance sheet.
A second reason for concern over the close links between government and central banks is that politicians have an opportunistic interest in there being some inflation. States are wrestling with massive debts, with a moderate growth outlook, there are three ways to dispose of debt: implement cuts, write it off or inflate it away.
Given that austerity-related cuts are electorally unpopular and write-offs undermine confidence, inflation is the only viable choice. For a government, public debt greater than gross domestic product is easier to control when currency debasement runs at 5% a year, as opposed to 2%.
Investors and citizens must be aware of the interests of politicians. They also need to understand the politicians’ greater influence on central banks. These closer links could mean that central banks are being frustrated in their desire to increase interest rates or stop the quantitative easing, resulting in inflation – and it is sensible to be prepared for this. After all, if you expect flooding from the North Sea, you can take preventive measures by raising the Thames Barrier.
Kommer van Trigt is head of rates at Robeco