The Looming Test for Central Bank Independence


In the first two columns in this series, I asked what the pandemic meant for short-term fiscal policy and, looking farther ahead, for measures to accommodate structural shifts in our economies. This time I’ll ask what it means for monetary policy — and the starting point is to look back at a key moment in history.

March 4 is the 70th anniversary of the Treasury-Federal Reserve Accord, the agreement that re-established the central bank’s independence and has underpinned it ever since. In subsequent years, the idea of central bank independence spread across the developed world. But will it survive?

After the Trump era of public criticism and veiled threats directed from the White House at the Fed, the inclinations of Treasury Secretary Janet Yellen and Fed Chairman Jerome Powell will favor cooperation — on the basis of the division of labor the 1951 Accord laid out. In the interests of long-run harmony, though, one should recall how and why the Accord was reached, and how this understanding might soon come under pressure.

From 1942, shortly after the U.S. entered the Second World War, until 1951, the Fed formally committed to help the Treasury by capping the interest rate on long-term U.S. government bonds at 2.5%. It did so to allow the federal government to finance the war more cheaply. Following the start of the Korean War in 1950, inflationary pressures led to a conflict between this commitment and the measures needed to meet the Fed’s mandate of controlling inflation. Tensions between the Fed and the Treasury increased.

Following a series of increasingly bitter and public exchanges, the two sides failed to reach agreement. Congress declined to intervene directly. But Senator Paul Douglas issued a plea in the Senate chamber on Feb. 22, 1951, “that the Treasury abate its policies and yield on this issue” and that “the Federal Reserve gird its legal loins and fulfill the responsibilities which I believe the Congress intended it to have.” Ten days later, the Fed was released from its commitment.

The Accord itself — admirably short — was published for the morning papers on Sunday, March 4, 1951:

The Treasury and the Federal Reserve System have reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government's requirements and, at the same time, to minimize monetization of the public debt. 

The Accord secured independence of the Fed in respect of monetary policy and paved the way for Paul Volcker to take drastic action in the early 1980s to bring inflation down. Note that the pact wasn’t designed to promote harmony between the two institutions, and it didn’t. Shortly after the Accord was signed, President Truman installed a new Fed chairman, William McChesney Martin, thinking he’d be more amenable to pressure from the White House. But Martin decided that his duty was to discharge the Fed’s mandate to control inflation. Truman was disappointed, and when the two later ran into each other in New York, the Fed chairman’s polite greeting was met by a one-word reply: “Traitor.” Truman was not the last politician to react to his central bank governor in that way.

The striking difference between then and now is that the pressure to keep rates low is coming from central banks themselves. Guided by the belief that any bad news requires a monetary response, central banks today are assuring financial markets that rates will be low for a long time, with some engaging in “yield curve control” to explicitly cap rates farther along the yield curve. They’re expanding the money supply rapidly at the same time as governments are running large budget deficits.

It’s surprising that officials do not see inflation even as a risk. The IMF’s chief economist said, in the context of President Joe Biden’s proposed fiscal stimulus, that inflation is nothing to be concerned about.” Last September, Philip Lane, the European Central Bank’s chief economist, said, “If you look around the world, this debate is everywhere about how to better tackle below-target inflation.” They may be right. But it isn’t difficult to imagine that a rise in inflation to levels above target would initially be welcomed by central banks to offset earlier undershoots of the target, then explained away as one-off “shocks” due to reluctance to abandon previous assurances of continuing monetary stimulus. At that point, a jump in interest rates might be necessary to control inflation, leading to a sharp market correction. Excessive confidence in forecasts and the models on which they rest is dangerous.

As Otmar Issing, the former intellectual leader of the ECB, remarked recently, “When reality demonstrates that central banks cannot deliver on expectations they are confronted with, or have even fostered themselves, their credibility will be lost.” Will we need another accord — whether in the U.S. or elsewhere — to preserve central bank credibility and independence in respect of monetary policy?

When Biden named Yellen for Treasury Secretary, he said a musical in the tradition of “Hamilton” was needed to celebrate the choice. One lyric comes to mind. During lockdown, many of us in Britain have been drawn to a mostly dreadful television series, “Riviera.” The best thing about it is its theme song, “Was It Love?” I imagine Yellen singing these words to Powell:

You and I are cut from the same ice
Sincerity made us the perfect heist
Burning all the gold to sapphire skies
But the breeze is cold in paradise
I can feel the whispers in the street
Every night I shiver in my sleep

All this world is mad, mad crazy
Trying not to drown in your mistakes
So I leave it up to faithless fate.

When it comes to the economy, fate will have its way — and the Fed’s assurances about interest rates might be swept away by some fierce currents. The best bet for staying afloat in such uncertain times is to keep our policy options open.

This and other documents of the time may be found on the website of the Federal Reserve Bank of Richmond and on the online repository of historical documents maintained by the Federal Reserve Bank of St. Louis.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mervyn King was governor of the Bank of England from 2003 to 2013. He is the Alan Greenspan Professor of Economics at NYU Stern School of Business and professor of law at NYU School of Law, and author (with John Kay) of “Radical Uncertainty: Decision-Making Beyond the Numbers.”

©2021 Bloomberg L.P.

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