Central Bankers Can't Return to Simpler Times

When Federal Reserve governors held an emergency conference call with the presidents of the regional Fed banks on May 9 to discuss the spreading Greek debt crisis, some policymakers voiced concern that lending a hand to Europe might not play well in the U.S. Congress. The Senate was in the middle of a debate to overhaul the financial system, and some Fed officials said that assisting Europe might encourage lawmakers to rein in the central bank's independence. In the end the Fed approved short-term currency swaps with foreign central banks after Chairman Ben S. Bernanke argued that the Fed needed to do what was best for the U.S. economy and could deal with the politics by better explaining its actions.

It's not the first time a central bank has confronted politicization, though the collisions have certainly increased as bankers—and their emergency rescue maneuvers—have become electoral fodder. It turns out that it's hard to retreat to a quiet life of making monetary policy after committing trillions of public dollars to save the global economy.

Even as the world's economies improve there are all sorts of new political demands confronting central bankers. In Britain, Bank of England Governor Mervyn King was asked to weigh in on the fiscal diet pieced together by the new Conservative-led coalition government, including $9 billion in budget cuts. (King pronounced it "very strong and powerful.") European Central Bank President Jean-Claude Trichet has had to defend his bank's purchases of troubled government debts as part of the region's nearly $1 trillion package to restore calm to financial markets. In the U.S., Bernanke has conducted a modified public campaign to burnish the Fed's image, touring a Tasty Baking (TSTY) cupcake factory in Philadelphia like a retail pol on May 13, and even chatting up employees.

Beyond removing central bankers from the important, time-consuming work of promoting economic growth while keeping inflation at bay, there are dangers to this trend. Monetary policy was designed to be conducted independent of political pressure for good reason: Central bankers are freer than lawmakers focused on the next election to take the painful steps needed to control inflation. Independent central banks also can better resist pressure to use the power of the printing press to finance government largesse.

If political considerations play a more prominent role in central banks' decisions, some economists worry that interest-rate policy could tip in the direction of short-term expediency. "We're getting far, far away from the model of the independent central bank," says Carnegie Mellon University professor Allan Meltzer, author of a two-volume history of the Fed. "We're going to end up with much higher inflation."

To prevent that from happening, central bankers need a new playbook to deal with the new pressures they're facing. They will have to do a better job explaining what they are up to and why, both to the public and elected officials, says New York University professor Mark Gertler, who co-wrote research papers with Bernanke when the Fed chairman was at Princeton University. At least a little politicking—both the grass-roots kind Bernanke conducted in Philadelphia and the back-channeling that is routine on Capitol Hill—is crucial to fending off political attacks on their independence.

So far the Fed looks to have beaten back its biggest threats, including a proposal by Senator David Vitter (R-La.) to allow continuous congressional audits of its policies. Bernanke took to the phones to persuade lawmakers to reject the measure while regional Fed presidents—led by Thomas Hoenig of Kansas City—pitched in by visiting lawmakers.

Other central banks have been less successful at preserving their autonomy. The South Korean government broke a decade-long precedent by sending a senior finance ministry official to the meetings of the Bank of Korea starting in January in an attempt to keep interest rates down. Bank of Japan Governor Masaaki Shirakawa doubled a lending program for banks in March, under pressure from Finance Minister Naoto Kan to do more to help the economy.

To ease the pressure on Greece and other European governments from surging interest rates, the ECB has begun buying sovereign bonds while stepping up its pleas to the region's political leaders to reduce red ink. There is no alternative to euro-area budget consolidation, Bank of Italy Governor and ECB Governing Council member Mario Draghi said on May 11.

The move, though, has shaken investors' faith in the ECB. "It's very unusual for a central bank to be buying what is distressed debt," says John Taylor, a professor at Stanford University and author of the Taylor Rule that policymakers worldwide use to help set interest rates. "It does raise questions about the independence of the ECB." Those concerns were fanned by comments from Axel Weber, also an ECB Governing Council member and president of Germany's central bank, that the bond purchases posed "significant" risks to the financial stability of the region.

With global investors growing more antsy about financing record budget deficits of the industrial nations, the demands on central banks to step into the breach are not likely to end soon.

The bottom line: Central bankers joined the political fray when they rescued their economies. Now they're finding it hard to retreat.

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