The End of An Independent Federal Reserve

The pandemic has accelerated the end of the era of independent central banks.  This is not necessarily bad: In many ways the case for independent central banks had lost its value.  But it is a major institutional change that will alter how economic policies work and present new risks and opportunities for investors.

The idea of central bank independence is relatively new.  National central banks began to be created in Europe in the 17th Century, and the U.S. Federal Reserve was founded in 1913.  Those central banks were servants of their governments.  The need for independence gained prominence in the 1960s and 1970s as inflation moved into double digits.  Associated academic work pointed to the incentives of governments to allow higher inflation.  Giving independence to central banks was thought of as a way to offset this incentive to inflate.

This motivation for independent central banks has lost much of its force.  For the developed world, at least, inflation is very much a 20th Century problem. Inflation in the United States has run well below the Fed’s target for more than a decade

The Federal Reserve also is losing its independence because its tools of monetary policy increasingly overlap with the tools of fiscal policy.  This process began in 2008 when the Fed began paying a market rate of interest on its liabilities (bank reserves).  Fed and Treasury liabilities became much closer substitutes.  At zero interest rates, even currency becomes a close substitute for Treasury debt.  When Fed and Treasury liabilities become such close substitutes, an independent role for “money” in steering the economy fades away.

QE drove further convergence.  QE is just public debt management, swapping Fed liabilities for government obligations.  Why is swapping reserves for coupon debt that different than swapping bills for coupon debt?  This year, Treasury is issuing trillions of dollars of near zero-yielding bonds and Fed is buying them, replacing them with near zero-yielding reserves.  Why should this matter?

Pandemic lending programs are fiscal policy.  The federal government already has huge lending/loan guarantee programs: the mortgage agencies, student loans, Ex-Im bank, etc.  Why involve the Fed?  The Treasury and Fed have worked closely together to design and implement programs like Main Street Lending Program involving the Fed in highly political decisions.  Lending IS spending (Fed policy IS fiscal policy) when the Fed takes credit risks or influences prices in credit markets.  The Fed has not articulated why it has had to be involved as much as it has been.

Implications:

Don’t think of the end of central bank independence as a question of good vs. bad.  It’s a new institutional setup that needs to be understood.  It does not mean, for example, that the Fed takes orders from Treasury; it means means Fed has less scope to act independently of Treasury and the broader federal government.  A more cooperative relationship between the Fed and Treasury could be quite positive for the economy if it allowed more creative policy responses, as for example in the response to the pandemic.  Alternatively, should inflation once again become an issue, a less independent central bank could well be a problem.

Inflation does not look to be an issue in the near term.  Economies have lots of slack, and the experience of the last expansion documented a strong disinflationary trend.  Consider as well the example of Japan.  Its government and the Bank of Japan have been trying vainly for decades to increase inflation.  Still, investors with a long time horizon need to keep an open mind and a flexible strategy; in paper money economies inflation risk is never dead.

The biggest danger in the loss of central bank independence is the greater likelihood of financial repression.  Fighting the pandemic is leading to levels of public debt not seen since the end of the Second World War.  Governments and economies cannot afford increased interest rate expenses on this debt.  The Fed will face implicit and explicit pressures to keep interest rates low.  Even if this does not lead to inflation, low yields depress market returns.  They punish current savers and encourage less-efficient investment projects.

A less independent Fed will make the moral hazard problems caused by current extraordinary monetary policies even more difficult to resist.  In each cycle over the past forty years the Fed has acted more broadly in the crisis phase and reversed less policy support in the subsequent rebound.  In the current episode the Fed has embedded itself deeply in program design and credit allocation.  It has purchased trillions of dollars of federal debt and promised support for the corporate and municipal bond sectors.  It will be difficult for the Fed to withdraw support for these bond/loan markets without causing renewed volatility and conflict with the federal government.  

Finally we face greater risks of a democratic backlash against an (unaccountable) Fed.  The Fed over the years has earned a strong reputation for competence and dedication to its goals.  This reputation will be at risk in the future as the Fed’s close involvement in fiscal action enmeshes it in political debates and attracts blame for policy outcomes.

Recognizing and guarding against these risks will require new attitudes and strategies for investors.  Fed decisions will be less predictable and will work in new ways.  Appointments to the Fed’s Board of Governors will merit closer scrutiny.