THE ECONOMIST: Central bank independence at risk as inflation and populist politics threaten global economies

The idea that central banks should enjoy some independence is as old as central banking. “I want (it) to be sufficiently in the hands of the government, but not too much,” mused Napoleon Bonaparte in 1806 of the recently created Bank of France.

Try telling that to President Donald Trump. He has spent the past year bullying the Federal Reserve to cut interest rates faster. The campaign escalated on January 11, when Jerome Powell, the Fed’s chair, said the Department of Justice had served the central bank with subpoenas.

Mr Powell said he is now under threat of a criminal indictment relating to a long-running spat over the cost of renovating the central bank’s headquarters.

The Trump administration’s actions are the most striking assault on the independence of central banks in decades, in part because the Fed is the most important central bank.

But it is not just in America that politicians are encroaching on monetary policy. Around the world, a decades-old arrangement that has, on the whole, brought lower inflation and greater economic stability can no longer be taken for granted.

The modern version of central-bank independence emerged after the second world war. The “Treasury-Fed accord” of 1951 liberated America’s central bank from having to keep down the government’s borrowing costs, as it had done during the war.

The movement gained traction in the 1980s as theoretical and empirical research built the case for independence. Politicians, the argument goes, are tempted by self-defeating monetary policies in pursuit of high employment, inflated away debts and election victories.

Mr Trump is not the only populist in power with strong views on monetary policy. Takaichi Sanae, Japan’s prime minister since October, had previously decried interest-rate rises as “stupid”. Bond markets moved sharply on her appointment.

Despite the Bank of Japan’s formal independence, what the government makes of monetary policy matters. In the 2010s the effort of Shinzo Abe, then prime minister, to end stubborn deflation included an accord with the bank, which hugely expanded its unconventional monetary stimulus.

That happened to be the right policy at a time of falling prices. Now Japan faces the opposite problem. In December inflation worries led the central bank to raise rates to a 30-year high.

Though her rhetoric has softened in office, fiscal and monetary policy are increasingly at odds. Because Japan’s net debt stands at 130 per cent of GDP, further increases in interest rates will rapidly squeeze the government’s budget, demanding fiscal tightening, not loosening.

Elsewhere monetary populists are not in power but waiting in the wings. In Britain, both the populist-right Reform UK, which leads the polls, and the populist-left Greens object to the government’s high interest bill.

Because the Bank of England bought lots of bonds during the financial crisis, a big chunk of this bill now runs through its balance-sheet. Bond purchases were paid for with the creation of new money — in effect, new deposits at the central bank. The interest paid on these “reserves” has swollen correspondingly.

Scrapping interest on reserves, which both Reform and the Greens have suggested, would amount to a tax on lenders, depriving them of income while leaving them on the hook for interest on deposits.

It would turn the central bank into a cash machine for the government, which may push for more bond-buying to reduce its overall interest costs. That might not be a problem if the Old Lady kept her independence. Yet Reform says “everything should be up for debate” when it comes to the central bank, including government oversight of interest-rate decisions.

The euro zone suffers from a related threat. Independence of the European Central Bank (ECB) is guaranteed by treaty, making it better insulated from politics than any other major central bank.

Although the euro zone’s overall debts are, at 88 per cent of GDP, just about manageable, the number is forecast to rise as governments shell out on defence and rapidly ageing societies while fending off populists who pan any budget cuts.

This is increasing the danger of another debt crisis in which the ecb must underwrite the most indebted governments. The central bank has already played this role, in the 2010s and again during the pandemic. In the 2010s it trod a fine line, guaranteeing to do “whatever it takes” to preserve the euro, while maintaining enough leverage to force governments to get their budgets in order. Low inflation early in the pandemic let the ECB justify bond-market interventions as necessary economic stimulus; it just so happened that this benefited the indebted countries most.

To the barricades

In today’s inflationary world, backstopping indebted countries is harder to justify. That might increase the central bank’s leverage over errant states, especially since nationalists in northern Europe would want less money-printing, not more. On the other hand, the most troubled country is now France, with debts of over 115 per cent of GDP and an annual deficit of 5 per cent of GDP.

The sheer size of the French economy — like that of Italy, another big debtor — would make it a formidable opponent in a game of chicken.

“We won’t be able to avoid a discussion with the (ECB) about French debt,” Jordan Bardella, a presidential favourite from the hard-right National Rally, told The Economist last year. At a minimum, the bank would be caught in the middle of another political fight

In developing countries, the main recent case of backsliding has been Indonesia. Its government is not especially indebted, but is raiding the central bank’s balance-sheet anyway. In September the Bank of Indonesia announced it had agreed to “share the burden” of funding the government’s pet projects, by increasing the interest it pays on the deposits of the finance ministry.

The bank has been buying government bonds afresh, too, and owns about a quarter of the rupiah-denominated stock. In unreformed countries like Ghana, Turkey and Nigeria, central bankers have faced prosecution or other legal trouble in recent years.

That Mr Powell finds himself in a similar predicament is a sign of just how topsy-turvy things have got in America. Even a successful pushback, which began with the Fed chairman’s spirited video denouncing the renovation probe, may bring only temporary reprieve.

Mr Trump will soon name a replacement for Mr Powell, whose term as chairman ends in May. One of the favourites is Kevin Hassett. He has serious economic chops but is a paid-up member of team Trump. Even if the president picks a true technocrat, the prospect of personal reprisals like those against Mr Powell must send a chill down monetary policymakers’ spines.

So would a Supreme Court ruling to let the president sack Lisa Cook, a Fed governor accused of irregularities on past mortgage paperwork (which she denies). The judges will hear arguments in the case on January 21.

You might expect all this to freak out the bond markets. Yet America’s ten-year Treasury yield is more or less where it was before Mr Powell spoke out. This may reflect his newfound gumption, and newly voluble friends.

Several Republican senators have said they would block Mr Trump’s nominations to the Fed until the case against Mr Powell is resolved. Mr Trump denied knowledge of the probe.

Another explanation for bond vigilantes’ quietude is the painful politics of inflation. One argument against the necessity of independent central banks is that inflation angers voters like little else. Jimmy Carter paid the price for it in 1980, as did Kamala Harris in 2024.

The enduring “crisis of affordability” remains the bane of incumbents everywhere. One thing keeping Ms Takaichi from more meddling appears to be that looser monetary policy would weaken the yen, which is unpopular with a public fed up with expensive imports. Maybe. But relying on politicians’ restraint is a huge gamble. Sticking with independent central banks, which have proved themselves up to the job time and again, is by far the safer bet.