Central bankers, usually considered being dull technocrats, make vivid headlines these days. Donald Trump is questioning the independence of the Federal Reserve (FED) and calls for lower interest rates. Jay Powell, the FED’s chair, is resisting Trump’s demands and now Jay’s job (and that of Lisa Cook, FOMC member) is on the line. In this blog we discuss central bank independence, starting with Emerging Markets (EM) before briefly turning to the FED (since what happens in Washington doesn’t stay in Washington but also affects EM).

New Washington consensus…?

Anybody investing in EM debt, especially in securities denominated in local currency, knows how important central bank independence is. The idea that central bank independence could be a good thing originated in the 1970s after a severe inflationary episode in the U.S. (inflation reached 13.5% in 1980) caused by the breakdown in Bretton Woods (resulting in devaluation of the dollar) and the oil shocks of 1973 and 1979. Current account surpluses in the Middle East were invested by (imprudent) international banks in EM government debt (EM at the time were referred to as LDCs), specifically in Latin America, without much or any credit analysis (Citibank’s then-chairman Walter Wriston famously said that “countries don’t go bankrupt”). In the following decade many EM countries defaulted because of unaffordable debt service costs as these countries took on too much debt whereas the Federal Funds Rate was hiked by then FED chair Paul Volcker to 19.1% (June 1981), resulting in an economic recession and adding the word “stagflation” to macroeconomic jargon. In the 80s, macroeconomists (led by Milton Friedman, godfather of “monetarism”, who laid the groundwork in the 60s) started to study the role of monetary policy on economic output and price levels. This led to the believe that it was best to target the growth rate of money supply instead of adopting a more “discretionary” monetary policy (i.e. ignoring money supply altogether). Indeed, Paul Volcker was an adept of Friedman’s thoughts. As the relationship between money supply growth and inflation (or rather nominal GDP) was not as strong as theorized, economists instead made the case for inflation targeting through setting (short-term) interest rates. Around the same time, another economic theory, that of rational expectations, gained traction. This is based on the simple idea that individuals make decisions based on all available information, including their own expectations about future events, and will update their views once new information becomes available. This also implies that individuals learn from past mistakes and try to work out implications from monetary policy. Only unanticipated changes in monetary policy (money supply) could increase economic output, but only temporary: individuals will not be fooled over and over again if they learn that the policy results in inflation, making them worse off. As creating surprises would undermine the credibility of monetary policy and the central bank, it was only logical to remove political influence from this process and plead for independence of the central bank. Politicians would be too tempted to print money to gain votes.

Chile and Mexico were the first EM countries to adopt inflation targeting (in 1991). Most other EM countries followed with Brazil, always a laggard, in 1999. Some countries initially had exchange rate targets as well (e.g. Chile, Israel) but these were later dropped. We would argue that a single policy objective is preferable as it is difficult to have an objective trade-off between multiple goals and a bank’s toolbox is limited (e.g. they can’t tax and spend, like a government). In our view, exchange rate targets don’t make much sense as exchange rates are determined by global factors over which the central bank has little control; therefore, we are very much in favour of floating exchange rates without any intervention (as many EM countries have adopted). Most larger EM countries have implemented inflation targeting now; notable exceptions were Argentina and Turkey, though both countries recently have changed track. Central banks generally can be regarded as acting independently from the government (Chile, Colombia, Mexico, Peru and Indonesia are good examples), although this does not always mean that politicians aim to influence central bank decision making (like Brazil’s president Lula calling for lower interest rates (to support his incontinent fiscal policies)) or that central bankers set rates to support a particular political party (like Adam Glapinski, the self-righteous governor of the National Bank of Poland, supporting PiS). It is not easy to empirically prove that central bank independence leads to lower and more stable inflation (the IMF has been developing a central bank independence index but results have not been published yet) but negative bond market reactions to central bank challenges by politicians suggest that independence is an important factor in investment decisions. The emergence of central bank independence coupled with inflation targeting allowed larger EM countries to sell local currency bonds to foreigners, finally overcoming “original sin”. A very positive development as it lessens the dependency on foreign portfolio flows (a domestic market for bonds can be developed) and the monetary policies of the FED and allowing for more effective fiscal policies, making the country’s financial system more robust and resilient.

Although inflation targeting suggests a rather mechanical approach (e.g. strictly following a rule, like the Taylor-rule), in practice most central banks exercise discretion over how they react to inflation numbers, for example by determining the pace of rate tightening (possibly depending on the deviation from target) or differing the approach depending on whether inflation is the result of a supply or demand shock. Also, FED rate decisions may be considered (usually in a defensive way, i.e. not easing before the FED does), especially if the country’s economy is highly dependent on the U.S. (e.g. Mexico).

Apart from implementing policies to obtain stable and low inflation, central banks also perform other tasks, the most important being providing liquidity to banks against good collateral as lender of last resort and to monitor the financial stability of the banking sector (bank supervision). There have not been significant bank crises in EM over the last 30 years or so other than in Russia (GKO default) and Ukraine (war). There have been sovereign debt crises (for example, Argentina, twice) but these were mostly related to external sovereign debt in dollars (Russia’s GKOs in 1998 being a big exception). A banking crisis easily might trigger a sovereign debt crisis as a bail-out would add to sovereign debt (most banks have limited bail-in debt instruments as they typically rely on deposits for funding). Fortunately, in most countries the banking sector is less developed (thus more profitable) and focused on consumer banking (which usually is more stable and diversified). Financial stability is likely to change in the coming years with the emergence of fintech banks (think of Nubank and Mercado Libre) and stablecoins (especially attractive in countries with a poor inflation management track record). Safeguarding the stability of the financial system (also referred to as macroprudential policy) in EM countries will become more essential. The BIS and IMF (should) play an important role in this area.

The final issue is whether the central bank should be able to lend to the government and/or buy government bonds. If the central bank is required to finance government deficits, then it will be difficult to implement inflation targeting (by setting interest rates) as the size of the bank’s balance sheet is effectively determined by the government. Government fiscal deficits are inflationary if investors believe it is not likely that the government can repay debt (by reducing expenditures or accelerating growth) but instead will inflate away the problem. In such case, increasing interest rates to fight inflation could aggravate debt unsustainability, possibly resulting in a weaker exchange rate which adds to the problem. We believe that central banks should not finance government deficits and, especially for EM, prudent fiscal policies are as important as inflation targeting and central bank independence. If central banks were to engage in buying government bonds, then this should explicitly be decided by the government in a transparent manner (including size and period).

Turning to the FED, we concur with most economists and investors that independence is sacrosanct though we recognize that independence never will be or can be absolute. Note that the FED has a dual mandate; next to price stability employment is also a target variable. As a trade-off between the two targets needs to be made, the decision inherently becomes political. In any case, given the limitations in respect to tools available to the FED to allocate responsibility for employment seems a stretch and managing employment by setting rates (and implicitly inflation) is rather fanciful. Having inflation as the FED’s sole objective seems more sensible to us.

One could also make an argument that the FED is too independent. Did it make sense to bail out venture capitalists holding uninsured deposits with Silicon Valley Bank? Or to accept government bonds as collateral against face value instead of (lower) market value? To buy corporate bonds, effectively subsidizing companies that have issued bonds but not helping companies that are dependent on bank financing? Should the central bank prop up stock markets by lowering rates (remember the Greenspan put?) in the name of ensuring financial stability (or irrational exuberance)? Was it wise to buy up nearly all new Treasury bonds issues during the covid-19 pandemic (which effectively is a fiscal policy, funding budget deficits)? Surely, the FED actions in reaction to the global financial crisis of 2008 and the covid-19 pandemic in 2020 were heavily influenced by politicians. We don’t necessarily have answers to these questions but it seems fair to us to ask them. Clearly, these issues are likely only to come up during a systemic crisis but should the FED take the lead or should the government bear that responsibility?

Yes, we are pro-independence, but we would change the target to inflation only and have a clear mandate what the FED can and cannot do. Financing budget deficits should be ruled out, in our view. Mr. Trump should refrain from challenging Mr. Powell, but we agree that Mrs. Cook should be fired if allegations of mortgage fraud prove to be correct. Although calling for lower rates by U.S. presidents is not a unique attribute of Trump (for example, Nixon and Reagan did the same), his aim to destroy institutions, including the FED (read a report written in March 2024 by Dan Katz and Stephen Miran, the latter recently being parachuted into the FED’s board), is very worrying. The FED saga should be viewed in this wider context and Congress should put a halt to it. The real numbskull here is Trump…