President can fire anybody at 'independent' agencies but the Fed is different: US Supreme Court

The US Supreme Court ruled that those in leadership positions at various independent agencies including the Federal Trade Commission serve at the pleasure of the US President. The President can, therefore, remove them at will.

Not so the members of the Board of Governors of the US Federal Reserve. They can be removed only for "cause" meaning the President must prove that they have done something that deserves removal. The court did not define what "cause" meant but indicated the threshold would have to pretty high. 

Why the different treatment?

Well, the Supreme Court contends that the many independent agencies are all part of the executive- they exist to enforce various statutes. As a result, they come under the authority of the President. And the President has the right to decide who he wants to work with. Period.

As for the Fed, it has been historically conceived as an agency that is independent of the executive. Without such independence, it cannot execute its mandate effectively. 

President Trump had fired Governor Lisa Cook on charges of  mortgage fraud. The US Supreme Court is saying those charges have to be proved and Cook must have the right to defend herself before she can  be removed.

In short, there is only one truly independent agency and that is the US Federal Reserve. The Fed is not an extended arm of the Treasury. All the other agencies cannot claim such independence. 

How Kevin Warsh got selected

I had a post yesterday on Kevin Warsh, the new appointee for Fed Chairman. 

By way of post-script, I want to write about the process followed for his selection. What I write is gleaned from various reports in the media. 

Warsh missed out on the job nine years ago when Trump gave it to Jerome Powell instead. According to reports in the media, Trump thought Warsh looked far too young to be taken seriously.

Soon after getting elected, Trump considered Warsh for the job of Treasury Secretary, a job that was given to Scott Bessent later.

For the Fed Chairman role, Bessent drew up a list of about ten candidates. After talking to them, he reduced the short-list to four. He had detailed meetings with the four where he asked them to spell out their views on interest rates, among other matters. The President then met all the four candidates. There was one more meeting between Warsh and Trump last Thursday after which Trump decided to go ahead with the appointment.

In this entire period, all names under consideration were in the public domain. Their views and comments on a range of matters were dissected and parsed in the media. The financial markets' reaction to some of the names could be discerned. For the short-listed four, betting markets sprang up. There were reactions on Capitol Hill to some of the prominent names, such as Kevin Hassett.

Hassett's chances dimmed after the Department of Justice announced an investigation of Jerome Powell's spending on the renovation of the Fed. Angry members of the Congress made it clear they would not process Hassett's appointment until Powell's case had been settled.

To cut a long story short, the selection of the Fed Chair took place in the full glare of publicity with the reactions of the markets and prominent public figures getting factored into the final selection. We have a pretty good idea of what we might expect of various candidates. And the process doesn't quite end there. The President's nominee has to be confirmed by US Congress. He will be grilled on his views and his record closely examined. It is a process that deserves admiration.

Quite different from some name being sprung on the public one day, would you say? 

What do we make of Kevin Warsh, Trump nominee for Fed chief?

Give credit where it's due. President Trump's appointee as Fed chief, Kevin Warsh, is exceptional talent- and he is nobody's stooge. Trump seems to have made a good call. 

Warsh is relatively young (55). At 35, he was the youngest member ever of the Fed Board of Governors when appointed to it in 2006. With his Kennedyesque looks, he may well be the most handsome Chair of the Fed in its history.

Warsh lacks the heavyweight academic credentials of Alan Greenspan, Ben Bernanke and Janet Allen, all three PhDs in Economics and the latter two big names in academia. He got his BA in public policy and then a JD in Law from Harvard. His background is similar to that of Jerome Powell's (BA in political science plus law). 

But that's precisely the striking thing about him- how many people with BAs get on to the board of a central bank and especially the Fed at 35? Prior to that he worked at the middle level in the M&A department of Morgan Stanley and then briefly in the Bush administration. It says something about the man's calibre that, with this fairly light experience, he could vault on to the board of the Fed. 

Warsh proved his mettle during the 2008 financial crisis when he served as a conduit to Wall Street, given his numerous contacts.  According to Ben Bernanke, his experience and insights helped contributed to the crisis-fighting strategy  of the Fed.   

Bernanke notes his contribution to the financial reform efforts that followed the crisis. He led a committee that conceptualised 'macroprudential regulation'. Bernanke writes:

"In late 2008, amid the crisis firefighting, we at the Fed began working on our own proposals for financial reform. I wanted to have a well formulated position before the legislative debates went into high gear. Kevin Warsh led a committee of Board members and Reserve Bank presidents that laid out some key principles. Kevin's committee considered a more explicitly 'macroprudential' or system-wide, approach to supervision and regulation. Historically, financial oversight had been almost entirely 'microprudential' – focused on the safety and soundness of individual firms, on the theory that if you take care of the trees, the forest will take care of itself. In contrast, the macroprudential approach strives for a forest-and-trees perspective." (Wikipedia)

Warsh disagreed vehemently with the Fed's persisting with Quantitative Easing beyond a point. His basic point was that the it went well beyond the remit of the Fed. That is a position he holds to this day. He warned- incorrectly, as it turned out- about inflation during the financial crisis and he expressed his opposition to QE2 while voting for it out of respect for Bernanke. Think of it- a BA arguing with a prospective Nobel Laureate on a topic on which the latter had made his reputation, banking crises! That shows confidence and it shows class.

Warsh left the Fed in 2011. He has since straddled the worlds of academic and financial markets. He's a Distinguished Visiting Fellow at the Hoover Institution and a lecturer at Stanford Business School, a testament to the fact that he's taken seriously in academic circles. In 2017, he was a contender for Fed Chairman. Trump eventually opted for Powell, partly because he thought that Warsh was too young and looked too young to be taken seriously as Fed chief! It was a decision that Trump came to regret- and that he has now set right.

Warsh has moved from hawk on inflation during the financial crisis years to a relative dove in recent years. He backs Trump's instinct for cutting interest rates and he thinks the Fed has underestimated the productivity boost to the US economy emanating from AI. His detractors see his shift as opportunistic but many grant that Warsh is not somebody who takes the independence of the Fed lightly. If he did, Trump may not have chosen him. Criticise Trump as much as you likes but he understands that without a credible and competent Fed, he cannot get the economy to perform. That's why he overlooked a couple of candidates who were perceived as excessively deferential to him.

Warsh favours a 'regime change' at the Fed. He wants the Fed get its balance right- he thinks at the moment its size is too big and its interest rates too high. Warsh would move to shed a big chunk of its portfolio. That would cause interest rates to rise. The Fed can then move to cut its policy rate with vigour. He has Trump's backing but he will need to carry his colleagues with him.

Call me an optimist but I can see Warsh at the helm of the Fed providing the right to support to Trump as he attempts a major reset of the US economy. 

Question mark again over Fed chief's continuance

"Numbskull", "fool", "moron", "stupid".... one has lost track of the expletives Trump has used to characterise US Fed chief Jerome Powell. Can you imagine anybody such things about the RBI Governor here? There would be a pretty strong reaction. Partly, I guess Trump's outbursts have to do with the incredible powers vested in the office of President of the United States.

Trump was inclined earlier to send Powell packing for not lowering interest rates. Media reports then said that Scott Bessent, his Treasury Secretary, had stayed his hand, pointing to the possible adverse reaction of the markets. The argument was that it's not done to remove a Fed chief who displays independence.

Trump is now hinting again at the possible removal of Powell. And he seems to be on more solid ground. The issue is the $2.5 billion the Fed has spent on renovation, including a cost overrun of $700 million. Various reports have highlighted details of the extravagance, including private lifts, dining areas, marble finishes etc. What is worse, Powell is said to have misled Congress on the issue by denying features in the renovation that, it turned out, were very much there.

Frankly, Trump is on strong ground this time around. It is wrong for a Fed chief to indulge in extravagance because the Fed is in many ways the custodian of the interests of ordinary people. And going on a spending binge on renovation sends out quite the wrong signals about where the Fed stands in relation ordinary people face. Especially when the Fed is at odds with the administration, it would be appropriate for a Fed chief to be watch his steps very carefully. Powell, it appears, has tripped up. Many will see his conduct as proof of the culture of impunity that pervades the higher echelons of power. 

Trump would, no doubt, be using the renovation issue as a pretext to replace Powell with somebody he finds more pliable and in line with his thinking. What does that say about central bank independence? 

That, I am afraid, is an over-rated idea. Heads of central banks are unelected officials. They cannot afford to be entirely out of line with the preferences of the democratically elected authority. Where the central bank chief does not see eye to eye with the political authority on a range of important matters, either he should step down or the government should have the right to remove him. 

In India, the RBI Governor serves as the pleasure of the government. More than one governor has stepped down after getting suitable signals from the government. The protection given to the Fed chief is misplaced. And ultimately it cannot help. If the President wants to go after a Fed chief, he can always find ways to do so- as the rumpus  over the issue of extravagance at the Fed clearly shows.

Why is media talking about Trump firing the Fed chief?

One is intrigued by the incessant speculation in the media about Trump's firing Fed Chairman Jay Powell once Trump is sworn in as president later this month. Kenneth Rogoff resurrects this speculation in a recent article but is quick to shoot down the possibility. 

By law, the Fed Chairperson has a fixed tenure. The President does not have the legal right to fire him or her. Of course, the President can get Congress to amend the law so as to enable to the President to fire a Fed Chief. But pushing through such legislation will not be easy despite the fact that Mr Trump is riding high at the moment. Opposition from Congressmen apart, Mr Trump has to risk with the damage such a move could inflict on the financial markets. Mr Powell, for his part, has said he has no intention of resigning.

Mr Trump can, of course, seek to undermine Mr Powell by criticising his moves. But he did so in his first term without inflicting any serious damage to the functioining of the Fed. Central bank independence does not mean the political authority cannot air its differences with the central bank in public. 

There is the larger question of whether the central bank chief must serve at the pleasure of the government. That is the case in India. It is open to the government to ask the RBI Governor to go- and without assigning reasons. That does not mean that is easy for any government to do so- as I mentioned earlier, the credibility of the central bank and the damage to financial markets and the economy are considerations that no government can brush aside. It's not easy to ask an RBI Governor to go even if the government has the authority to do so.

That apart, the RBI is not in the same position as the Fed. The Fed focuses on monetary policy and has some responsibility for bank regulation. The RBI is a full-scope central bank encompassing monetary policy, bank regulation, exchange rate management, government borrowings, currency management etc. Independence of the central bank is about independence in monetary policy. Such independence cannot extend to the other areas for which RBI has responsibility.

Lastly, chemistry at the top is important. The head of government must have a certain degree of comfort with the central bank chief . Where that comfort level is not there, the government should have the right to replace the central bank chief. That is not to say that the central bank chief must be a stooge of the government- no intelligent head of government would even want that because ultimately politicians in a democracy do feel the need to deliver. And they would understand that having an independent central bank is crucial to that objective. 

Central banks have won the battle against inflation

 

As inflation soared to levels unknown in decades in two years ago, central banks came in for severe criticism for not reining in demand earlier.  Bring inflation down to target would mean a huge sacrifice of growth, critics said.

They have been proved wrong. Inflation has been brought down over the past two years with a modest sacrifice of growth. One has lost count of the number of analysts who said last year that the US economy was sure to slip into recession, if that had not already happened.

Central banks have improved their tool-kit over time. However, as I argue in my recent article in BS, Central banks have the last laugh,  their success in the recent bout of inflation owes to several factors beyond their control.

Central banks have the last laugh

The world economy will grow at 3.2 per cent in 2024 and 2025, says the International Monetary Fund’s (IMF’s) latest Economic Outlook. That is below the 3.6 per cent growth rate seen during 2006-15. Yet, the relief over the growth projections is almost palpable. 

There is relief because  the battle against record levels of global inflation has been won- or so the IMF declares- without as much loss of growth as was feared. Inflation rates are trending down without the global economy going into recession. Commentators who had been critical of central banks’ responses to post-Covid inflation have been proved wrong.  

Global inflation peaked at 9.4 per cent year-over-year in the third quarter of 2022. In the US, the inflation rate rose to 9.1 per cent in June 2022. Since then, inflation rates have been dropping. Global headline inflation rates is now projected to reach 3.5 per cent by the end of 2025,   below the average level of 3.6 per cent between 2000 and 2019. 

As inflation started surging after the Covid-19 pandemic, central banks were roundly criticised for tightening too little and too late. Since central banks were slow to react, critics said, monetary tightening would have to be extremely aggressive. A soft landing was almost impossible.  

Central banks have also been faulted for being slow to loosen monetary policy when the inflation rate began to decline, and growth was seen to be faltering. Might they have done anything differently? Since the actions of central banks were broadly synchronised, let us focus on the actions of the US Federal Reserve.

The pandemic was correctly seen as giving rise to a supply shock as well as a demand shock.  Monetary (and fiscal) policies to boost demand were entirely appropriate.   Expansionary policy caused the inflation rate in the US to rise above the target rate of 2 per cent in March 2021. 

Once the pandemic-induced restrictions were progressively removed through the second half of 2021, producers found it difficult to ramp up output due to supply chain disruptions. Demand ran ahead of supply, the US inflation rate surged.  There was an expectation that as supply bottlenecks eased, inflation would come under control. In any case, the Fed could not have been expected to tighten policy when the pandemic was still raging.

By December 2021, the inflation rate in the US had touched 7 per cent.  Just as central banks were preparing to tighten policy in early 2022, there came another shock-- the onset of conflict in Ukraine in February that year. Oil prices rose sharply amid expectations that the oil market would be severely disrupted. Inflation in the US shot up to 7.9 per cent in February. By mid-2022, global inflation had tripled relative to its pre-pandemic level. 

The Fed commenced tightening from mid-March 2022, with a 25 basis points (bps) increase in the policy rate. By June 2022, the policy rate in the US had jumped by 150 bps. By July 2023, the rate had gone up by more than five percentage points. Should the Fed and other central banks have tightened even more and even earlier in response to the Ukraine conflict? 

The short answer is that central banks’ responses to such events can only be tentative.  Could anybody have imagined that the conflict in Ukraine would go on for over two years? And that, two years into the conflict, oil prices would be contained at below $80 a barrel, thanks in part to the EU/NATO-imposed price cap on oil imports from Russia?  How much to tighten monetary policy and at what pace in response to such events can only remain in the realm of guesswork.

Suppose the Fed had indeed tightened earlier. What might have happened? The IMF’s Outlook uses a model to examine the outcomes had the Fed tightened three quarters earlier than observed. It finds that peak inflation would have been 2 percentage points lower than what was observed. However, real gross domestic product (GDP) would have been 0.2 percentage points lower. The model suggests that the Fed got the timing right.

 Inflation in the US stayed above 5 per cent until March 2023. Even last September, it was above the target rate of 2 per cent. The conventional wisdom is that when inflation stays high for so long, it is very difficult to get the inflation rate to fall without a substantial sacrifice of growth. Yet the sacrifice of growth has been minimal. 

There are several explanations for this seeming miracle. 

First, as the IMF points out, inflation expectations stayed “anchored”, that is, people did not change their long-term expectations. One can only speculate as to why this happened. It may well be that the credibility of central banks has gone up in recent years.  Economic agents may have seen the pandemic and the deviations from the inflation target that happened as a black swan event.    They may have believed that central banks had the competence to bring inflation to heel sooner rather than later.

Secondly, the Phillips curve appears to have steepened during the high inflation period. This implies that any monetary tightening and the economic slack it creates would result in a greater reduction in inflation than when the Phillips curve is flatter. Central banks end up producing better results than in normal times.   But then how on earth are central banks to anticipate the steepening of the Phillips curve in such times?

Thirdly, high inflation rates did not trigger a wage-price spiral that would have rendered the inflation rate stubborn. One reason certainly is that the power of trade unions in the advanced economies has declined  and workers have less bargaining power. 

Fourthly, the increase in commodity prices was less than, say, during the oil shock of the 1970s, and the energy-intensity of economies itself has declined. Inflation caused by commodity shocks is intrinsically less of a problem today, and a lighter hand is needed to deal with it. It is fair to say central banks have been helped by a combination of favourable factors.

One issue remains. Should central banks have started cutting rates even earlier? Well, with the geopolitical risks that we face, central banks have to tread warily. The conflicts in Ukraine and West Asia have escalated. Either could have spun out of control –and still can. The American presidential elections have posed their own uncertainties. No central bank wants to loosen policy only to tighten soon thereafter.

 Getting policy right in the face of so many imponderables will always be a challenge. In the present round, central banks have had the last laugh. Whether their success is due to tactical genius or pure serendipity is anybody’s guess. 

 

Central bank autonomy

This is now an old debate. But it's worth getting the perspective of Y V Reddy on the subject in India Forum. 

Reddy begins by noting that the RBI is a full service bank. It appears that bank regulation was added to RBI's mandate down the road along with various functions:

The important functions of the RBI include issue of currency, monetary management, banker to banks and the government, management of public debt, and management of foreign exchange reserves. Over a period, it has subsumed and assumed powers to regulate money, securities and foreign exchange markets, regulation of banks and non-banks and payment and settlement systems. In serving the public good, the RBI has traversed a long distance and faced many challenges. In the process, it has evolved into a full-service institution encompassing regulatory and developmental roles in the financial system, besides partnering with union and state Governments as their fiscal advisor in domestic and external sector policies.

Reddy gives the arguments for and against central bank autonomy. For autonomy:

The first is what is called time inconsistency. Essentially, it means that the time horizon of democratically elected government is short-term and hence they may favour growth over price stability. However, on matters relating to money, actions have to be taken keeping a long-term view. The central bank is expected to take a longer-term view......There is a second reason: that there are political cycles and there are business cycles, which do not coincide. For instance, elections will encourage politicians to have expansionary policies at that time... The third reason is that governments have a tendency to spend more money than appropriate and some limits have to be put on the spending. These can be put in the Constitution. This can also be enforced by independent central banks.

Against autonomy:

There is no democratic legitimacy for a technocratic body to decide on the important matter of money...Second, the independence of central bank may result in friction between fiscal and monetary authorities. Third, a central bank may 'impose' its outlook and preferences on the people, contrary to democratic preferences.

The tricky question is how to enforce accountability. Reddy gives some suggestions:

They should provide regular reports on their policy decisions and the economic outlook and be subject to external audits. Transparency helps build credibility and public trust in the central bank's actions. 

I have advocated external audits for all autonomous government institutions, including RBI. But hardly any of it happening.  It happens rarely and when it does happen, it is perfunctory.

Moreover, central bank autonomy can be largely in respect of the conduct of monetary policy. On various other matters that the RBI handles, such as bank regulation, foreign exchange and management of public debt, there has to be close consultation with the government. Autonomy cannot be sought across the entire range of a full-scope central bank's activities because ultimately the government is accountable for outcomes in a way in which the central bank is not.

  

Central banker jokes

RBI Deputy Governor Michael Patra's recent speech on monetary policy transmission will be of interest to many. The part I liked best was where he cracked a couple of jokes at the expense of central bankers.

These are not the best times for central bankers to wax eloquent. From being knights in shining armour during the pandemic, they have become much maligned and are held responsible for the darkening outlook globally. The story is told of a man stuck in a traffic jam in the capital of a major economy. He asks a policeman about what is going on, and is told that the Governor of the central bank of the country is so depressed about the economy that he wants to douse himself with gasoline and set himself on fire. So, in sympathy, the crowd has decided to take out a collection for him. “How much has been collected?” asked the man. The answer: “40 gallons”.

Here's another one:

A man needs a heart transplant. The doctor offers the heart of a five-year old boy. “Too young!” says the man. “How about the heart of a 40-year old treasury head?” “He doesn’t have a heart”. Then how about the heart of a 75-year old central banker?” “I will take it!” “But why?” “It’s never been used!” 

 If a central banker can laugh at himself, there is still hope for the breed.

Should central banks prioritise inflation or growth this year? No easy answers

Central banks in advanced economics cannot make up their minds whether they should priortise growth over inflation in the months to come. That is because it's hard to predict how the Ukraine conflict will shape. 

At the moment, they have prioritised inflation. But if the conflict worsens, growth will be the bigger problem. My column in BS today, Central banks haven't got it wrong.

FINGER ON THE PULSE

Central banks haven’t got it wrong

TT RAM MOHAN

Central banks in advanced economies are today in thrall to the conflict in Ukraine. Emerging market central banks, in turn, are in thrall to the actions taken by the US Federal Reserve. Those who fault  central banks for their response to inflation in recent months seem to gloss over these facts.

During the global financial crisis of 2007, central banks knew what they had to do- loosen monetary policy and keep doing so. Likewise, during the pandemic. Now, the course is nowhere as clear.

The conflict in Ukraine has rendered the conduct of monetary policy extremely difficult. There is still no knowing how the conflict will pan out. Western sanctions against Russia are unprecedented in their scope and severity. And it’s hard to say how Russia will respond as the conflict rages on. 

The US Federal Reserve faces an unenviable task.   With the inflation rate in the US at 9.1 per cent in June, analysts warned  that a recession was imminent.  Some claim that the US is already in recession. This would imply that the Fed should go slow on rate hikes to fight inflation.

Hold on. After the last meeting of the Federal Open Markets Committee, Fed  Jerome Powell poured cold water on talk of a recession. US unemployment rate in July was 3.5 per cent, which was the level before the pandemic set in. This meant that the Fed should tighten more aggressively, not less so, as the recession school contended.

If that is not confusing enough, the conflict in Ukraine is a huge imponderable. Do we know whether or not the impact of Ukraine on the world economy is played out? If central banks reckon that the oil price will stay in the range of $100-110, they would be justified in concluding that inflation is the bigger threat at the moment. However, if Russia moves to cut supplies drastically, all bets on oil prices are off and growth is seriously threatened.  

JP Morgan Chase has warned that, in an extreme scenario, Russia could slash dramatically oil supplies in response to the oil price cap imposed by the West. Oil prices could then surge to $380 dollar a barrel. At that price, global growth will collapse and inflation will cease to be the priority for central banks.

So great is the uncertainty created by Ukraine that, after the last meet, Mr Powell refrained from providing forward guidance, that is, any indication of exactly what rate hikes to expect in the coming months. Nor is the Fed in a hurry to return to the inflation target of 2 per cent for the US. It seems quite happy to return to the target by end 2023.

If the task for the Fed is so complicated, the challenge for central banks in emerging markets, including the RBI, can well be imagined. In addition to factoring in the outlook for growth and inflation, they have to keep a wary eye on the exchange rate. Coping with the “spillovers” of Fed policy is testing the mettle of emerging market central banks.

That should explain the stance taken by the Monetary Policy Committee (MPC) of RBI earlier this month. The MPC made no change to its forecasts for growth and inflation in 2022-23. Nevertheless, it thought fit to increase the policy rate by 50 basis points. The MPC argued that the increase was needed to anchor inflation expectations and to bring the inflation rate closer to the target of 4 per cent.  

That does not sound very convincing. With the actions taken so far, the RBI can at best hope to bring the inflation rate down to the target only by end 2023, exactly as the Fed intends to. The RBI, like the Fed, has chosen not to provide forward guidance.

The more plausible explanation is that the RBI is keen to manage the exchange rate of the rupee after the Fed’s rate hike of 75 basis points. The real effective exchange rate of the rupee against a basket of currencies has been steady over the past year. Analysts have argued that we could do with a depreciation in the real effective exchange rate in order to boost exports.

However, when it comes to managing capital flows, it is the exchange rate with respect to the dollar that matters. The dollar is the safe haven for funds. In order to stem the outflow of capital, it is important that the rupee not depreciate too much with respect to the dollar. If portfolio investors sense a steep depreciation with respect to the dollar, they will flee the rupee. The RBI’s policy rate moves are thus substantially dictated by the Fed’s own.  One wonders whether the RBI would have thought it necessary to raise the repo rate if the Fed itself had settled for a more modest increase.

On a broader note, critics of central banks say that central banks failed to catch the impetus to inflation post the pandemic. Many believe central banks have laid the ground for stagflation similar to the one witnessed post the oil shocks of 1973 and 1979. As the annual economic report of the Bank for International Settlements (June 2022) makes clear, the critics are off the mark.  The behaviour of commodity prices this time has been different from that in the 1970s. So are the economic backdrop and monetary policy regimes.

First, the oil price shock has been less severe this time around. Oil price have increased by 50 per cent since mid-2021 and are around their long-term averages. In 1973, oil prices doubled in a month and touched historic highs. Secondly, higher energy prices impact growth to a less extent today because of the reduced energy-intensity of GDP. Thirdly, the 1973 rise in prices happened on the back of several years of rising inflation. In contrast, today’s episode follows years of low inflation. Lastly, the institutional frameworks for monetary policy and for anchoring inflation expectations are far more robust today.

Forecasts of economic doom in the year ahead are premature and central bank-bashing is misplaced. Central banks are not behind the curve on inflation nor is a soft landing inconceivable  in the US. To be sure, things could change dramatically if the conflict in Ukraine worsens. But that is hardly something central banks can prepare for.

(ttrammohan28@gmail.com)

 

 

Scepticism about inflation targeting: Edward Chancellor

Inflation targeting has become the norm in many countries, including India. Edward Chancellor, journalist, historian and author, sounds a sceptical note in this article. He has provided a more elaborate critique in a book, The Price of Time.

Chancellor says that inflation targeting has allowed central banks to set ultra-low interest rates in response to bouts of deflation and to justify the same by citing the inflation target given to them. As long as inflation stays below target, the interest rate set by a central bank is okay.

Chancellor thinks that is not okay. There are a number of malign effects of ultra-low rates that must be taken into account:

Yet these targets produced a number of corruptions and distortions. Ultra-low interest rates pushed the US stock market to near record valuations and provided the impetus for the “everything bubble” in a wide variety of assets ranging from cryptocurrencies to vintage cars. Forced to “chase yield”, investors assumed more risk. The fall in long-term rates hurt savings and triggered a massive increase in pension deficits. Easy money kept zombie businesses afloat and swamped Silicon Valley with blind capital. Companies and governments availed themselves of cheap credit to take on more debt.

Central banks must, therefore, be guided not just by the level of inflation but also by its effects of interest rates on asset valuation, financial stability, leverage and investment. In other words, we are back to multiple objectives for central banks instead of a single objective, namely, inflation! 

This may sound plausible. Except that, elsewhere, Chancellor argues that the alternative to ultra-low interest rates is simply to not respond to bouts of depression because they tend to cleanse the economy of unproductive or inefficient firms. That is more than a little extreme. The idea that governments should have stood by when the pandemic erupted is hard to swallow. You must read Martin Wolf's critique of Chancellor's  book to get the complete picture. It is all very well to ask central banks to take asset bubbles into account but we know that that is a notoriously difficult task. When is an increase in asset values a bubble? We do not have a clear answer. 

At the same time, as Wolf points out, it is important to take on board Chancellor's plea to factor financial stability into central bank policy. The interest rate is a useful tool for battling recession. At the same time, central banks must address threats to financial stability through various instruments of regulation. Excessive leverage is an issue both in the financial sector and in the corporate world. Wolf says that removing tax deductibility for debt must be part of the solution. The solution has been urged by many. The time may have come to consider it seriously.

No, we don't need austerity, says IMF!

 The IMF does not prescribe austerity any more- at least not for the advanced economies.

The advanced economies have resorted to a large fiscal stimulus in response to the pandemic. The IMF World Economic Outlook, October 2020, estimates that discretionary stimulus amounts to 9 per cent of GDP in advanced economies (compared to 3.5 per cent of GDP in emerging economies). 

Public debt in advanced economies is poised to rise by a full 20 percentage points to 125 per cent of GDP by the end of 2021 (in emerging economies, the figure will be 65 per cent of GDP). Yet, the IMF thinks the rise in debt will not be a big deal for the advanced economies.

Why? Because interest rates have fallen to close to zero in the advanced world, so more debt does not translate into an unsustainable interest burden. There's more debt but it's cheaper now. As a result, by 2025, overall deficits will be back to pre-pandemic levels without any cuts in public spending, according to a report in the FT:

Most advanced economies that can borrow freely will not need to plan for austerity to restore the health of their public finances after the coronavirus pandemic, the IMF has said in a reversal of its advice a decade ago. Countries that have the choice to keep borrowing are likely to be able to stabilise their public debt by the middle of the decade, Vitor Gaspar, head of fiscal policy at the fund, told the Financial Times. That would mean they would not have to raise taxes or cut public spending plans.

As the report notes, this is a change in the IMF's position with respect to what it had advocated after the global financial crisis.

The IMF is now urging advanced economies to spend their way out of trouble. Growth will take care of debt sustainability because the growth factor 'g' will outweigh the interest rate factor 'r'. 

But the point is that this - the positive gap between growth and interest rate- is not happening by accident. It is happening because central banks are intervening in the debt markets to make it happen. Central banks first allowed the policy rate to drop to close to zero at the lower end of the yield curve. Then, they resorted to Quantitative Easing which is the purchase of a defined amount of government bonds from investors. They have followed this up with Yield Curve Control, which is defining the interest rate they want to see at the higher end of the yield curve.

If central banks elsewhere can make it easier for governments to borrow, why is it a problem if the RBI does the same here? Why is the management of interest rates to facilitate more government borrowing and spending such an issue here? Why the criticism that fiscal dominance dictates monetary policy?

There is merit in what the proponents of Modern Monetary Theory are saying. They say that it's not true that government borrowing drives up interest rates because there is a limited pool of savings to finance it. When the government spends, the interest rate falls, it does not rise. There is an accretion to bank reserves at the central bank. This causes the inter-bank rate, which is the anchor rate in advanced economies, to fall, thereby facilitating more government borrowing and spending.

There is only one constraint in central banks allowing interest rates to fall: the fall in interest rates must not spell higher inflation. This is a constraint in India at the moment, given that inflation has been at over 6 per cent in recent months, that is, beyond the upper bound of the the inflation target framework. However, once the inflation rate falls, there is nothing that stands in the way of a cut in the policy rate. And until then, managing yields at the higher end of the curve is par for the course.