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There's much debate about how to proceed on monetary policy, but on at least one basic point there can be no argument: history clearly shows that central banks must be independent if they're to be effective stewards of a nation's currency. Simply put, the political factor has no place in central banking. Yes, it leaks in from time to time, but every effort should be made to keep it at arm's length. The issue is more than window dressing. A large body of evidence shows that central banking works better when the political influence is reduced, ideally to zero.

Bernake Photo
Bernanke meeting with Sen. Dodd and Treasury Secretary Paulson on Tuesday

With that in mind, a central bank's independence flows from two fonts of power and influence. Ultimately, one is at risk when the other's threatened, or is perceived to be threatened. The first is the fundamental autonomy that's driven by the opportunity to weigh decisions based solely on the economics, i.e., monetary decisions that are unbound from the political aura that otherwise informs government action. The second source of a central bank's authority and efficacy is what one might call soft power: the ability to shape perceptions in the market by tools other than the hard power of changing interest rates, adjusting money supply, etc. Giving speeches, for instance. Soft power draws heavily on the prevailing pool of respect for the central bank and a belief in its integrity for effecting change based on the economic merits. And the market's belief in that integrity relies in no small part on the assumption that the Fed's impervious to the political winds du jour.

Make no mistake: we're not worried that Fed Chairman Ben Bernanke is suddenly in the pocket of Senator Chris Dodd and Treasury Secretary Hank Paulson. The Fed's still independent and we have no doubt that it will continue to set policy based on the merits. But the image projected at yesterday's public meeting of the three men at this particular moment will, we think, raise awkward questions if the central bank cuts the Fed funds rate in the near future.

Yes, it's important for the various branches of government to communicate. Given what's going on in the capital markets these days, more communication is better. But, hey, a private phone call or confab would work just as well, right? What, we wonder, was accomplished by a very public highlighting of the fact that politicians and their representatives are keen on seeing the Fed lower interest rates? On the eve of what may be emergency cuts in Fed funds, does it help to see the Fed head being pressured to lower rates by the Senate banking committee chairman, who just happens to be running for president and represents a state that's home to more than a few hedge funds?

To be fair, in a news conference on Tuesday, after meeting with Bernanke, Dodd said he applied no direct pressure on the Fed chairman to lower rates. The Senator did say, however, that "it's time to act. The ball is really in their court." But there's no pressure.

It will shock no one to remind that politicians always and forever think interest rates should be lower. That's the nature of politics: provide relief now, soon and preferably before the next election. If there's any fallout, well, that can be addressed later.

The Federal Reserve, by contrast, is in the business of making decisions that will echo in the financial markets and the economy a year, two years, even five or more years down the road. As such, the enormous power that resides in the world's most important central bank should be dispensed thoughtfully, carefully and with much deliberation and respect for the numbers. In addition, the decisions should be as free of political influence, in both reality and perception, as possible. That's why the Fed chairman isn't elected by popular vote. Why? More often than not, doing the right thing in central banking isn't popular.

That said, lowering interest rates may or may not be wise at this point. But whether the Fed cuts, raises or stands pat, every effort should be made to insure that the decision is driven exclusively by economics and not politics. We're sure that standard will be maintained. There is no quid pro quo, even though someone might now think otherwise in the wake of the new imagery. In short, Tuesday's photo op, didn't help.

Source: Power, Influence and the Federal Reserve