Holding on to the Central Bank Concept
What are the key objectives of a central bank? What are the instruments that it uses to help achieve its target? Is the its responsibility restricted only to a country's monetary policy? Just how independent is it from the government?
The answers to these questions are not as straight forward as they once were. The objectives and the activities of central banks have evolved and changed. The struggling global economy is posing new questions about their roles and strategies. The banks in turn are resorting to unconventional strategies and policies to boost growth and bring stability to financial markets, in addition to their primary objective of bringing in stability in prices. The line between the roles of policy makers (both monetary and fiscal) have now become much thinner.
The past year is a case in point. Central banks proposed, and in some cases, acted on policies that, for them, were quite unconventional. Examples include: the European Central Bank's Outright Monetary Transactions (OMT) and liquidity injections, including the Long Term Refinancing Options (LTRO); Quantitative Easing (QE) by the Bank of England, the U.S. Federal Reserve and the Bank of Japan; and the shift in FED's stance away from inflation to growth and now to employment.
As a result, the balance sheets of these and other central banks have continued to expand, in some cases pushing some asset prices to artificial levels.
Another harbinger of change occurred in 2012 was when the independence of the Japanese central bank was challenged by the government, which not only changed the institution's inflation target, it also revamped the bank's leadership. This is not only the example of a political dominance but also fiscal dominance as monetary policy is subordinated to the decisions of those who decide fiscal policies. A similar case happened in Hungary when the European Commission accused the Prime Minster for threatening the independence of the central bank.
In an era of very high public debt, governments are urging central banks to expand their monetary bases to finance budget deficits. The rise in inflation during this process is also welcome as it deflates the public debt. The recent "Coupon Raid" conducted by the UK Treasury on the Bank of England is a case in point. The interest earned on gilts purchased by the BoE through its QE program were directly transferred to the government for managing its public finances. An even more original (one might say outlandish) example of political influence on central bank monetary policy was the idea floated by members of the U.S. Congress of having the Treasury Department mint a trillion dollar platinum coin and sending it to the FED in order to pay off.
As unusual as the events of 2012 were, 2013 promises more of the same, with central bankers on standby mode to counter any risks. Although there is hardly any room for further accommodation in the developed world via the regular instruments, central banks could continue to be accommodative via unconventional channels.
At the same time, given renewed optimism about a H2 global recovery gaining momentum, there is a possibility of a monetary policy exit in the latter half of the year in the developed world. Central banks in emerging economies will also stay on hold for now, with the possibility of an exit as growth gathers momentum. However, further loosening is expected in some countries such as India, Brazil, Turkey, Hungary and Poland where sluggish growth requires immediate action.
With the gradual erosion of central bank independence, markets in 2013 now face a new risk from a round of competitive exchange rate devaluations by central banks or increased politicization of exchange rates, such as the one stated by the Bundesbank. For example, the ECB may face a challenge if other central banks overlook their own inflation targets and act to lower their exchange rates against Euro to make their exports more competitive against those of the Euro Zone.
With the growing influence of the political class on central banks, such actions no longer remain a distant possibility.