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Is the era of central bank independence nearing its end? Now that Donald Trump is back in the White House, questions are being asked. The president-elect has made no secret of his desire to bring the Federal Reserve, the world's largest guardian of the reserve currency, to its knees.
Of course, the benefits of an independent central bank can be overstated. Central bankers created persistently low inflation during the 1990s and 2000s, the era of Great Moderation, when in fact price stability was primarily a product of global labor market shocks. I believed in myself. This is a result of the integration of China and other developing countries into the global economy. Thereafter, a major shift occurred in the balance of power between labor and capital, and the distributional struggle between debtors and creditors tilted in favor of the latter. Central bankers have also not done a remarkable job managing the recent surge in inflation following the coronavirus pandemic and Russia's invasion of Ukraine.
However, the alternatives to central bank independence are hardly acceptable. To see the point, just consider the massive politicization of monetary policy from time to time in Türkiye and Argentina. The ability to conduct monetary policy insulated from government pressure is clearly valuable. The logic is that elected governments have an incentive to reduce unemployment in the short term at the expense of long-term effects on inflation and growth. If you have a lot of debt, you also have an incentive to rely on inflation to reduce the real value of your debt.
As voters in the 1970s and 1980s understood, such trade-offs are dire. As a result, monetary policy makers around the world lost confidence. It took sky-high interest rates, a global recession, and a reinvigoration of central banks by the Fed's Paul Volcker to get the world back on a low-inflation path. Confidence is everything in monetary policy.
There is good reason to believe that the Fed's independence in pursuing its dual mandate of promoting maximum employment and stabilizing prices is extremely important under the Trump administration, where Republicans hold majorities in both houses of Congress. President Trump has promised to pursue a number of inflationary macroeconomic and trade policies, including broad tax cuts, heavy import tariffs, and mass deportations of immigrants, which will severely tighten the labor market. In fact, the US economy would face a large supply shock at the same time as expansionary fiscal policy. This is due to higher inflation and stronger It shows that it is becoming unstable.
Add to this the quirk of Trump's obsession with cryptocurrencies. Maurice Obstfeld, former chief economist at the IMF, said that most cryptocurrencies, with the exception of stablecoins, are disconnected from the real economy and operated beyond the reach of public policy, making cryptocurrencies less susceptible to inflation. He points out that this poses an unprecedented threat. Therefore, they introduce significant uncertainty into financial transactions and represent an unreliable basis for economic decision-making.
Despite the Fed's impressive success in stemming a recession while bringing inflation down to near its 2% target, some on Capitol Hill are promoting cryptocurrencies as a solution to central bank failure. Obstfeld noted, for example, that Republican Sen. Mike Lee has characterized the dollar as “unstable” due to its alleged role in fueling the federal budget deficit. He has introduced legislation that would prohibit the Fed from issuing its own digital currency. According to Obstfeld, if enacted, the ban could further widen the scope for unregulated cryptocurrencies and encourage illegal activities. This would reduce the Fed's influence over the economy.
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Additionally, U.S. Sen. Cynthia Lummis of Wyoming introduced legislation in July to create a “Strategic Bitcoin Reserve,” which would strengthen the U.S. financial position and reduce economic uncertainty. He said it would serve as a hedge against financial instability. In reality, the crypto bubble is primarily a product of ultra-loose monetary policy following the 2007-2008 financial crisis. Not only is it highly volatile, but it also has great potential to create financial instability, bailouts, and recession risks.
Is this all indicative of a Liz Truss-like fiasco and bond vigilante field day, you might ask? The simple answer is that this is unlikely, as the world's reserve currencies enjoy so-called exorbitant privileges. Unless a country offers a market as deep and liquid as U.S. Treasuries, caution is not a big buy. Still, the combination of massive public debt issuance and President Trump's notorious unpredictability is a toxic combination for markets. The U.S. bond market will likely experience turbulent times in the future. Be prepared for financial instability.
john.plender@ft.com
