Feb. 9 (Bloomberg) -- The global financial crisis is forcing the world’s central bankers to surrender some of their prized independence. Regaining it won’t be easy.

More than a principle is at stake. For longer than a quarter-century, independent central banks have been able to take painful and politically unpopular measures needed to restrain inflation. The worst economic calamity since the 1930s leaves Federal Reserve Chairman Ben S. Bernanke, Bank of England Governor Mervyn King, Bank of Japan Governor Masaaki Shirakawa and their colleagues under pressure to align policies with those of their nations’ elected leaders.

As a result, policy makers may find it harder to act whenever the time finally comes to begin soaking up the money with which they’ve flooded the globe.

“The lines between central banks and governments are becoming fuzzier,” says Nouriel Roubini, a New York University economist. “Inflation is the path of least resistance for politicians, but it is dangerous.”

Finance ministers and central bankers from the Group of Seven nations will discuss what more they can do together when they meet Feb. 14 in Rome. What’s brought them to this point is the collapse of credit markets, which has robbed traditional monetary policy of much of its punch.

The U.S. risks a deflationary economic decline -- in which output, prices and wages all fall -- even after repeated interest-rate cuts that have driven the overnight bank lending rate close to zero. In response, Bernanke has joined with the U.S. Treasury in unprecedented steps to revive credit.

Buying Up Securities

Meanwhile, King and Shirakawa, his British and Japanese counterparts, are set to start on the same course after seeking a go-ahead from their governments to buy up private-sector securities.

“Monetary authorities and the fiscal authorities are working hand-in-glove,” Canadian Finance Minister Jim Flaherty said in an interview.

While that may be necessary now, it could turn into a problem later. Some Fed policy makers have already stressed the need to move quickly, once the crisis passes, to sop up all the money they have pumped into the financial system. Critics charge that the Fed and other central banks laid the groundwork for the current turmoil by not raising rates fast enough once the 2001 recession passed.

Inviting a Crisis

“The importance of doing this correctly cannot be overemphasized,” Federal Reserve Bank of Kansas City President Thomas Hoenig said in a Jan. 7 speech. “We have sometimes been slow to remove our accommodative policy, and in doing so, we have invited the next round of inflation, excess and crisis.”

Treasury Secretary Timothy Geithner has voiced the opposite concern, noting that Japan in the 1990s and the U.S. in the 1930s snuffed out incipient recoveries by prematurely tightening credit. He has vowed not to repeat that mistake.

His views carry considerable weight at the Fed. Not only is he a former New York Fed Bank president, but the Treasury is providing seed capital for many of the credit facilities the central bank will ultimately have to unwind -- including $20 billion to cover any initial losses on the Fed’s planned $200 billion program to promote loans to students, small businesses and auto buyers.

‘First Loss’

“If you have Treasury taking the first loss, you may feel some responsibility to take their advice,” says Vincent Reinhart, the Fed’s former director of monetary affairs and now a resident scholar at the American Enterprise Institute in Washington.

What’s more, the Treasury may end up playing a greater role in helping the Fed soak up the hundreds of billions of dollars of liquidity it has pushed into the financial system. That’s because of changes in the size and makeup of the Fed’s balance sheet.

In the past, the Fed has withdrawn money from the market by selling Treasury debt it holds to private investors. Those holdings have now dwindled, even as the balance sheet has ballooned, because the central bank has been swapping its Treasuries for riskier, harder-to-sell assets in an effort to revive the credit markets.

That means the Fed may need to rely on the Treasury to sell bills on its behalf when it wants to withdraw money from the economy. The Fed’s flexibility “could be blocked by a Treasury decision,” Reinhart says.

Short-Term Assets

Bernanke plays down the difficulty. “A significant shrinking of the balance sheet can be accomplished relatively quickly,” he said in a Jan. 13 speech, in part because many assets the Fed holds are short-term and thus can be retired routinely as they come due.

Some of Bernanke’s colleagues fret that the Fed has also opened itself up to political interference by allocating credit to certain sectors of the economy according to the types of securities it purchases. Stanford University Professor John Taylor dubs that strategy “mondustrial” policy -- a hybrid of monetary and industrial policy.

In response to comments Taylor made during a Jan. 3 panel discussion in San Francisco, Federal Reserve Bank of St. Louis President James Bullard said he’s “very concerned” about maintaining independence.

The Fed isn’t alone in radically remaking the way it does business. With its benchmark rate now at a record low of 1 percent, the Bank of England is undergoing the biggest changes to its monetary-policy framework since it won control over interest rates in 1997.

Unfreezing Markets

The British government last month granted King authority to spend 50 billion pounds ($73 billion) on bonds and commercial paper as a way of unfreezing markets. The Debt Management Office will sell Treasury bills to pay for the purchases. To use the fund for stimulating the economy by boosting the money supply, the central bank will first need permission from Chancellor of the Exchequer Alistair Darling.

“This is something that could only be done with the Treasury and the Bank of England working hand in hand,” Darling said last month.

Thomas Mayer, chief European economist at Deutsche Bank AG, says the Bank of England may struggle more than the Fed to reassert itself, given that it has been independent for only 12 years.

Spurring Growth

In Japan, Shirakawa cut interest rates in December after the government lobbied the Bank of Japan to spur economic growth. He has now asked the government for approval to buy up to 1 trillion yen ($11 billion) of shares owned by financial institutions. Still, he has criticized a push by some lawmakers for the government to begin printing money.

The European Central Bank under President Jean-Claude Trichet has been more reluctant to tie its policies to those of national governments -- in part because there are 16 of them in the euro region, from Germany to Malta.

Trichet is already playing down the likelihood that his bank will cut rates to zero and has refused to give odds on whether it will need to buy securities.

ECB Executive Board member Jose Manuel Gonzalez-Paramo cited one reason for the central bank’s reticence in a Feb. 6 speech. Direct purchases of securities might compromise a central bank’s independence by exposing the bank to credit risk, he said in Granada, Spain. That could force policy makers to turn to their governments for more capital, he said.

Exhausting Options

Rather than take that risk, central bankers would be likely to “exhaust all other options” in order “to preserve price stability,” he said.

Another reason for the ECB’s reluctance: the risk of political flak if the central bank’s purchases were perceived to favor one nation’s economy over another’s.

“Any debt-purchase program implemented by the ECB involves risk-sharing between members, and that’s highly political,” says Jacques Cailloux, chief Euro-area economist at Royal Bank of Scotland Group Plc.

Still, Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London, says the ECB will be forced to start buying commercial paper within months to combat the financial crisis.

Other monetary policy makers are having their independence tested too. Iceland’s central bank Governor David Oddson is defying a demand from the new government to resign, accusing it of “little disguised threats.” Colombia’s central bank, pressured by President Alvaro Uribe over the past year to lower rates, will soon have a board composed almost entirely of his appointees when he fills two more seats.

“The deflationary environment is closing off options for central banks to act independently,” says Stephen Roach, chairman of Morgan Stanley Asia and a former Fed economist. “It’s very worrisome.”

To contact the reporters on this story: Rich Miller in Washington at rmiller28@bloomberg.netSimon Kennedy in Paris at Skennedy4@bloomberg.net

Last Updated: February 9, 2009 07:24 EST