Special Report, Outlook 2015: Giving up freedom for security
When the Labour government came to power in the UK in May 1997, one of its first policy decisions was to make the Bank of England – the world’s second-oldest central bank, after Sweden’s – independent. At the time, the government was praised for being politically neutral and far-sighted.
Scroll forward 17 years and the enthusiasm for the government ceding control of the Old Lady of Threadneedle Street seems somewhat quaint, after the financial crisis and subsequent adoption of quantitative easing in the UK and the US effectively re-wrote the rulebook on the role central banks can play. Nonetheless, the importance of that decision should not be minimised.
Rob Drijkoningen, co-head of emerging markets debt strategies at Neuberger Berman, says: “There is empirical evidence that an independent central bank both reduces the level of a nation’s inflation as well as its volatility.”
Eric Weisman, fixed-income portfolio manager at MFS, adds: “It’s universally believed the more independent a central bank, the more adroitly macro policy will be able to handle anything that is thrown at the country.”
However, this independence can be a somewhat nebulous concept. To provide a more systematic assessment of a central bank’s independence, five different aspects can be measured.
• Political independence. Is the bank open about its policy objectives – is it targeting price stability, growth, or a certain value for its nation’s currency, free of government inteference?
• Economic independence. Is the bank transparent about the data, models and forecasts it uses?
• Procedural independence. Does the bank demonstrate independent decision making through its published minutes and votes?
• Policy independence. Does the bank make prompt announcements and provide explanations for its decisions?
• Operational independence. Can the bank choose to use the instruments it needs to achieve predefined targets, when it needs them?
“Academics have used these five measures to assess how independent are the world’s 120 central banks,” says Kaan Nazli, senior economist of the emerging markets debt team at Neuberger Berman. “According to these criteria, central bank independence has improved from 1998 to 2010.”
However, an independent central bank cannot be achieved in isolation – both the governance framework and the economy must also be well developed.
“The GDP per capita needs to have reached a reasonable level, while there also needs to be strong rule of law as well as a lack of corruption,” says Nazli. “The independence of a central bank is a good measure of the progress of a country’s economy and its government – the more evolved they are, the more independent the central bank will be.”
In recent years, emerging markets have started to catch up with their developed market peers as their central banks have become more independent.
But while central bank independence around the globe has increased, it has become a less pressing concern for fixed-income investors in recent years.
“When inflation is a problem then central bank independence is vital because it is able to take the policy measures it needs to lower cost prices without interference from the government,” says Michael Biggs, emerging markets investment manager at GAM. But, he adds, when the threat is, instead, one of stagnation and deflation, central bank independence is less important because conventional monetary policy can go no further than taking interest rates to zero.
The more unconventional, unorthodox measures required in that situation – pursued to some degree by the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – simply cannot be implemented with the same level of independence as conventional monetary policy measures.
“To provide economic stimulus requires fiscal and monetary policy working in concert,” as Biggs puts it.
David Riley, head of credit strategy of BlueBay Asset Management, agrees: “Major central banks are now much more in the political limelight because there is a much greater focus and reliance on monetary policy to help to stimulate the economy after the financial crisis.”
While the central banks have not relinquished their independence to become a branch of the treasury department, their switch of focus onto unconventional policy measures, such as quantitative easing, has significantly changed their role.
“Central banks have moved from their backstage role of inflation controllers to a centre-stage position of supporting the economy, which has entailed much greater public and political scrutiny than they were subject to in the past,” says Riley.
The G3 of the Fed, the ECB and the BoJ have tripled their balance sheets over the past five years, to a total of $9trn, which is signficiant in itself but which also has a significant impact on all other central banks.
“It’s not only that the G3 are all pursuing the same strategies, it’s that they appear to be acting in concert, which has a significant impact on other central banks,” says Putri Pascualy, partner at PAAMCO.
Riley agrees: “This does change the parameters of what central banks can do – wherever they are in the world.”
Take emerging markets, for example. The G3 and G4 policies have led to artificially low interest rates in the developed world, that has sent capital flooding into emerging markets looking for better returns. This, in turn, can create asset bubbles that can burst in the face of equally sharp reversals in capital flow – as happened during the ‘taper tantrum’ of summer 2013.
“Other central banks are forced to be much more reactive rather than proactive, because they are effectively riding the tidal wave of liquidity from the G3 banks,” notes Pascualy. “Their job has become to stay on top of the announcements made by the G3 and try to read the tea leaves to predict what will happen next.”
With the exception of China – which has the necessary resources and tight capital controls to protect the value of its currency – rather than being able to set and pursue their own monetary policy, central banks around the globe are now focused on the machinations of the G3. At the margin, they can shore up their own balance sheets and stabilise their own internal market.
But it may not be so important that most emerging market central banks cannot currently act in a truly independent manner. Many emerging economics are now in much better fiscal shape than the developed economies, boasting healthier internal and external balance sheets and private and public sector debt dynamics.
“This gives strong emerging markets some breathing space and they can afford to sit back and learn the lessons of the developed world’s current policies over the next few business cycles,” says Weisman.
One of those lessons that emerging market central banks may choose to learn is that the conventional mantra that independence is always a good thing is a flawed argument.
The unconventional actions taken by the G3 in fiscal and monetary policy have set a new tolerance for these types of policies.
“The policy example set by the G3 governments and central banks has had an impact,” says Graham Stock, BlueBay’s head of emerging market sovereign research. “These expansionary policies have made it more difficult for more cautious policy makers to argue that they were not appropriate for emerging markets.”
Weisman agrees: “Emerging market central banks may now not become as independent as they would have had the financial crisis never happened.”
One of the unforeseen consequences of the financial crisis may well be that such august institutions as the IMF, as well as academics and economists, may have to re-evaluate their previous conclusions that central bank independence is always the best option.