–Must Clarify Fiscal, Monetary Policy Dividing Line

By Steven K. Beckner

(MNI) – Although the worst of the perceived threats to the Federal
Reserve’s independence have seemingly gone by the wayside, Fed Chairman
Ben Bernanke continued to argue the case for keeping central banks free
of political pressure in a visit to Japan Tuesday.

Bernanke, in remarks prepared for the Bank of Japan in Tokyo, said
politicians should set the goals of monetary policy but leave the
conduct of policy to the central bankers. The latter should, in turn, be
“accountable” and “transparent” to the government.

Bernanke also stressed the need to mark a clear “dividing line”
between monetary and fiscal policy, particularly when it comes to
“quantitative easing” policies. Otherwise, he said there is a danger of
debt “monetization” — governments using the central bank’s money
printing power to finance their deficits.

Bernanke spoke as House and Senate conferees were preparing to meet
to finalize an historic financial regulatory reform package.

Throughout the legislative process, the Fed has lobbied hard to
resist proposals it saw as a threat to its independence, including
Congressional audits of Fed monetary policy decisions, presidential
appointment and Senate confirmation of Federal Reserve Bank presidents
and stripping the Fed of its supervisory authority over state chartered
member banks.

Recently, however, the more offensive provisions of House and
Senate bills have been stripped out going into the House-Senate

Under the bill that passed the Senate, for example, the Government
Accountability Office, would conduct only a one-time examination of the
Fed’s emergency lending to financial institutions during the financial
crisis. It would retain supervision of state-charted banks as well as
over bank-holding companies.

Under the House bill, the GAO would be given broader power to
conduct audits of the Fed. And the Fed would lose consumer protection
regulation authority and ability to unilaterally inject money into
financial institutions.

Taking no chances, Bernanke said, “In undertaking financial
reforms, it is important that we maintain and protect the aspects of
central banking that proved to be strengths during the crisis and that
will remain essential to the future stability and prosperity of the
global economy.”

“Chief among these aspects has been the ability of central banks to
make monetary policy decisions based on what is good for the economy in
the longer run, independent of short-term political considerations,” he
said. “Central bankers must be fully accountable to the public for their
decisions, but both theory and experience strongly support the
proposition that insulating monetary policy from short-term political
pressures helps foster desirable macroeconomic outcomes and financial

Bernanke said “the goals of monetary policy should be established
by the political authorities, but that the conduct of monetary policy in
pursuit of those goals should be free from political control.”

“To achieve both price stability and maximum sustainable
employment, monetary policymakers must attempt to guide the economy over
time toward a growth rate consistent with the expansion in its
underlying productive capacity,” he said. “Because monetary policy works
with lags that can be substantial, achieving this objective requires
that monetary policymakers take a longer term perspective when making
their decisions.”

“Policymakers in an independent central bank, with a mandate to
achieve the best possible economic outcomes in the longer term, are best
able to take such a perspective,” he said.

On the other hand, Bernanke warned, “policymakers in a central bank
subject to short-term political influence may face pressures to
overstimulate the economy to achieve short-term output and employment
gains that exceed the economy’s underlying potential.”

“Such gains may be popular at first, and thus helpful in an
election campaign, but they are not sustainable and soon evaporate,
leaving behind only inflationary pressures that worsen the economys
longer-term prospects,” he said. “Thus, political interference in
monetary policy can generate undesirable boom-bust cycles that
ultimately lead to both a less stable economy and higher inflation.”

Bernanke warned that “undue political influence on monetary policy
decisions can also impair the inflation-fighting credibility of the
central bank, resulting in higher average inflation and, consequently, a
less-productive economy.”

If a central bank has anti-inflationary credibility, “it will tend
to be self-fulfilling, as inflation expectations will be low and
households and firms will temper their demands for higher wages and
prices,” he said. “However, a central bank subject to short-term
political influences would likely not be credible when it promised low
inflation, as the public would recognize the risk that monetary
policymakers could be pressured to pursue short-run expansionary
policies that would be inconsistent with long-run price stability.”

“When the central bank is not credible, the public will expect high
inflation and, accordingly, demand more-rapid increases in nominal wages
and in prices,” he continued. “Thus, lack of independence of the central
bank can lead to higher inflation and inflation expectations in the
longer run, with no offsetting benefits in terms of greater output or

Bernanke also warned that “a government that controls the central
bank may face a strong temptation to abuse the central bank’s
money-printing powers to help finance its budget deficit.”

The Fed chief pursued that issue further, touching on the concerns
of many officials that some of the Fed’s extraordinary anti-crisis
measures came perilously close to the borderline between monetary and
fiscal policy.

“The case for independence also requires clarity about the range of
central bank activities deemed to fall under the heading of monetary
policy,” he said, adding that this is particularly true of
unconventional monetary policy which involves setting targets for
short-term interest rates or quantitative easing.

“As fiscal decisions are the province of the executive and the
legislature, the case for independent lender-of-last-resort authority is
strongest when the associated fiscal risks are minimal,” he said.
“Requiring that central bank lending be fully secured, as is the case in
the United States, helps to limit its fiscal implications.”

“Looking forward, the Federal Reserve supports measures that help
further clarify the dividing line between monetary and fiscal
responsibilities,” he continued. “Notably, the development of a new
statutory framework for the resolution of failing, systemically
important firms is not only highly desirable as a means of reducing
systemic risk, but it will also be useful in establishing the
appropriate roles of the Federal Reserve and other agencies in such

Bernanke said “the issue of the fiscal-monetary distinction may
also arise in the case of the nonconventional policy known as
quantitative easing, in which the central bank provides additional
support for the economy and the financial system by expanding the
monetary base, for example, through the purchase of long-term

“Although quantitative easing, like conventional monetary policy,
works by affecting broad financial conditions, it can have fiscal side
effects: increased income, or seigniorage, for the government when
longer-term securities are purchased, and possible capital gains or
losses when securities are sold,” he said.

“Nevertheless, I think there is a good case for granting the
central bank independence in making quantitative easing decisions, just
as with other monetary policies,” he said. “Because the effects of
quantitative easing on growth and inflation are qualitatively similar to
those of more conventional monetary policies, the same concerns about
the potentially adverse effects of short-term political influence on
these decisions apply.”

“Indeed,” Bernanke added, “the costs of undue government influence
on the central banks quantitative easing decisions could be especially
large, since such influence might be tantamount to giving the government
the ability to demand the monetization of its debt, an outcome that
should be avoided at all costs.”

** Market News International **

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