By Sidharth Wagle

Abstract

This article will explore the conflict between the macroeconomic objectives of central banks and their invisible accountability to the people. In this exploration, we broadly analyze the actions of the Federal Reserve as evidence for the existence of this conflict.

1. Introduction

Often, a large majority of the population views the economy through a short-term lens, prioritizing unnecessary government expenditure over long-term fiscal sustainability. As such, governments are incentivized to compete with each other on the promise of extraordinary spending through government programs. Unlike elected governments, however, the political autonomy of central banks supposedly allows them to not be subject to this short-termism, and instead prioritize fiscal responsibility and avoid overheating by targeting inflation in the economy. 

As we will see, this autonomy is a bogus assumption. In practice, the modern world places invisible pressures on the central bank to make politically- favorable policy choices at the long-term cost of the taxpayer, often for the immediate benefit of multinational corporations. The speculative nature of the stock market has made stock prices incredibly sensitive to even the slightest indicator of unfavorable monetary policy from the central bank, as shown in 2017 when Wall Street pinned future expectations on speeches by members of the Federal Reserve as opposed to legitimate financial data. This volatility has incentivised central banks to prioritize growth and booming markets, even if it comes at the expense of high inflation. Without this growth, the public would view the central bank as ineffective, damaging confidence in the economy and eroding the effectiveness of the monetary policy. The rest of this article will specifically analyze these new unwritten objectives of central banks through an examination of the policy decisions of the United States’ Federal Reserve and the Reserve Bank of India.

2. The New Focus on Growth

It has been widely observed that during the lockdown and its consequent economic ailments, the Federal Reserve overextended itself from a regulator of interest rates and inflation watchdog to an “all-purpose policymaker”, intervening in broad swathes of sectors and excessively pouring money into the economy under the assumption that inflation rates would continue their 20-year low trend. Nonetheless, this belief reveals that the bank forgot the reason for the preceding 20-year lull in inflation, specifically the fiscal discipline imparted to the Federal Reserve during the tenure of Ben Bernanke, whose policies could not be more in contrast with those of today. 

Firstly, despite a recovering economy and a sizable fiscal stimulus from the Biden government, the Federal Reserve, either due to unreliable forecasts or a desire to portray an image of growth, did not increase interest rates, loosening the reins on an economy that was already overheating. Little to most economists’ surprise, the United States’ inflation rate subsequently peaked at 9.1% in June 2022, an overwhelming indicator of out-of-control growth and the necessity of a monetary intervention to prevent consumer prices from ballooning further. An alternative explanation for this high inflation is Russia’s invasion of Ukraine and the subsequent rise in energy prices due to supply chain difficulties. Even after accounting for this rise, the US inflation rate would still be a whopping 6.5%, a level virtually unseen since the stagflation of the 70s. 

3. The Risks

Inflation is a double-edged sword. Although it releases Keynes’ “animal spirits” by disincentivizing saving and thus encouraging consumer expenditure, it has a persistent upward tendency and once unleashed, it is difficult to regain control of.  The Federal Reserve’s decision to temporarily ignore their inflation target of 2% heralds a growing trend across the world. The decision for central bankers to engage in the kinds of short-termism before only undertaken by vote-seeking politicians, and signals their prioritization of economic growth over low and stable inflation. The impacts of this policy reversal, especially as the world economy returns to its previous levels of development, could be dangerous. 

Without an autonomous and disciplined central bank to rein in inflation, the United States’ real debt reduces. This could seem desirable, however, this reduction comes at an obvious cost to lenders, who are now more likely to charge an inflation premium on their lending so as to offset the impact of future inflation. If this happens, the inflation payments of the US will increase, forcing governments to draw further deficits and potentially encouraging growth-oriented central banks to bail the government out by purchasing government bonds. Such a policy would lead to further borrowing in the long term, drowning America and along with it, the rest of the world, in lousy debt- setting the scene for an inevitable economic collapse. 

4. Ripples in India

Other parts of the world have not been immune to this trend either. The Reserve Bank of India (RBI) had reduced the interest rate to a “record low of 4%” at the height of the lockdown and, similar to the Fed, refused to raise interest rates after, causing food and fuel prices to skyrocket and propel inflation to an 18-month high in 2022. However, the focus on growth is more muted in India, given that the RBI did raise interest rates multiple times after inflation peaked. Nevertheless, the fact that interest rate increases were a passive response to an overheated economy rather than an active preemptive measure is another indicator of the new orientation of central banks away from price stability and toward artificially supporting economic growth indicators.

Conclusion

More recently, however, the Federal Reserve has begun engaging in interest rate hikes. Nevertheless, inflation remains high. This conflict between price stability and economic growth hardly seems a modern problem. It is natural, then, to turn to history and investigate the outcomes of similar previous situations where central banks have attempted to tackle the dual problems of runaway economic growth and the accompanying price inflation. Historically, no central bank has ever been able to create disinflation without a recession, implying that sooner rather than later, the Federal Reserve will face the tough choice between curbing growth sharply or allowing consumer price indices to spiral out of control- a choice that, in the light of the Federal Reserve’s recent policy decisions, seems heavily biased toward the latter. 

About the Author

Sidharth Wagle is a first-year undergraduate at Ashoka University interested in the intersection between data, economics, and public policy. 

Image Source: https://www.economist.com/leaders/2019/04/13/the-independence-of-central-banks-is-under-threat-from-politics