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Trump attacks on Fed set bad example for Asia

Myth of central bank independence helps protect objective monetary policy

| India
Reserve Bank of India Governor Shaktikanta Das is seen as politically malleable.   © Reuters

One of the sustaining myths of modern economics is that central banks are independent, able to pursue monetary policy free from the pressures of politics. Donald Trump is demonstrating once again that this is, indeed, a myth.

In his latest intervention on April 5, the U.S. president urged the U.S. Federal Reserve to "drop rates" and turn the economy into "a rocket ship."

His comments echo around the world, including Asia. Commentators ask not only what the direct global economic impact might be but also what the effects of Trump's criticisms of the Fed are on relations between governments and central banks elsewhere.

The issue is fundamentally the same: how far can a central bank diverge from the often-conflicting objectives of politicians, without exploding the valuable myth of independence?

The complexities of this question have been demonstrated in the United States. Trump's attack last week reopened an argument after a few weeks of self-imposed silence following a previous high-volume criticism in December.

The Federal Reserve then raised interest rates despite the president's clearly articulated opposition. The Open-Market Committee knew that its actions would offend Trump, but members had little choice. Throughout 2018 the Committee had signaled its intentions through "forward guidance," with specific prediction of four rate hikes in the year. Thus, to miss the fourth increase in December would have been tantamount to announcing a return to the Arthur Burns/Richard Nixon era, when Fed Chairman Burns saw his role being to carry out whatever Nixon deemed necessary to facilitate the president's re-election.

President Donald Trump then went quiet. Having asserted its independence in December, the Committee was able to use its March meeting to reset the policy environment and point toward monetary easing. The immediate risk of an independence-sapping confrontation with the president has gone. At the same time the risk of the Fed losing credibility through overly-tight policy has lessened. Fed independence has been maintained.

But now Trump has raised the stakes by publicly calling for an interest-rate cut.

How are Asian central banks coping with their similar balancing act? Indonesia, India and China provide contrasting narratives of central bank independence.

The intersection of economics and politics is most acute when the politicians have to win elections, so Indonesia and India currently present contrasting examples of the interplay. During the second half of 2018 both countries were subject to foreign capital reversals, with exchange rates under pressure.

The proper response is to tighten both monetary and fiscal policy. This slows economic activity, which reduces the current-account deficit, taking pressure off the exchange rate. Meanwhile, the exchange rate can be allowed to slide a little, improving international competitiveness. Judicious intervention reassures foreign exchange markets that the fall will not be so much as to threaten inflation.

The slower growth at the heart of this strategy is, however, politically unpalatable. If financial markets accept that the central bank has the freedom to pursue good policy, most foreign capital stays put and the pain is lessened.

This was precisely the Indonesia response. Bank Indonesia raised interest rates, in small steps, from 4 1/4% to 6%. The exchange rate was allowed to depreciate modestly, with Bank Indonesia doing just enough intervention to assure markets that things were under control. Memories of the 1997 exchange-rate plunge remained just that -- memories. Since then Bank Indonesia has maintained this firm stance. The cost in terms of lost growth has been small.

As far as outsiders can judge, all this took place without intervention from President Joko Widodo. Having a former Bank Indonesia governor as coordinating economic minister may have helped the discussion around the cabinet table.

India, on the other hand, came into this same testing period in 2018 with the Reserve Bank of India already under pressure, following the 2016 upheaval of demonetization, when high-value notes were abolished. One high-profile reformist governor departed after a single term. His successor lasted only two years. His replacement, Shaktikanta Das, is seen by many as politically malleable. Two interest rate reductions so far this year are seen as sops for Prime Minister Narendra Modi's election, even if they can be justified by a weaker economic outlook. India survived the external pressures of 2018 but the Reserve Bank's independence has been undermined.

Zhou Xiaochuan speaks with IMF Managing Director Christine Lagarde: Without formal independence, Zhou achieved satisfactory short-term outcomes.   © Reuters

China is quite different, with no formal semblance of central bank independence. Yet the Peoples' Bank carries the helpful legacy of the outstandingly successful period under Governor Zhou Xiaochuan. Without formal independence, Governor Zhou achieved satisfactory short-term outcomes and significant structural reform. Past success provides future freedom to act, even without a framework of independence. It remains to be seen whether this aura has passed undiminished to his successor Yi Gang. This leaves no room for mistakes: the governor has to pull off the magician's trick of being right all of the time.

For all these differences, each central bank rode out the challenges imposed in 2018 well enough. Does this mean that central bank independence doesn't matter much after all?

This would be a dangerous presumption. The full extent of the RBI's loss of independence was not apparent until Governor Urjit Patel resigned suddenly at the end of 2018, by which time the exchange-rate pressures had abated. Two rapid interest rate reductions coming so soon in the regime of the new governor will be taken by market cynics as an indication that next time interest rate increases are needed, the RBI will be slow to respond. Markets will be on tenterhooks, ready to take their money and run.

Independence, like beauty, is in the eye of the beholder, or in this case the skeptical judgment of fickle financial market investors. It is in the nature of financial markets that they are volatile. Foreign investors will once again retreat from emerging markets. The low-interest hiatus created by the U.S. Fed's pause gives the Asian economies a breathing space to shore up their reputation for independence.

There are three key elements: appointment of senior central bankers; the decision-making process for monetary policy; and the political skill of the governor.

Central banks can't be independent in the sense of being autonomous institutions, free to do what they want and choose their own leaders. Governments always have the right to appoint top central bankers. It is only established precedent and public scrutiny that can ensure that appointees will be technically competent and politically neutral, rather than pliable.

An operational rule, such as inflation targeting, provides both government and the central bank with the decision framework which can resist political pressure.

This still leaves an essentially political task for the governor: to demonstrate a readiness to resist the wishes of the government if necessary, but without being so defiant as to lose the job.

The fragile myth of independence must be nurtured during the good times, to minimize the necessary but painful response to the inevitable shocks.

Stephen Grenville is nonresident visiting fellow at the Lowy Institute in Sydney and former deputy governor of the Reserve Bank of Australia.

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