How the Fed Second-Guesses Its Own Independence

by: Felix Salmon

Greg Ip says that the Fed would have expanded its quantitative-easing program by now were it not for political considerations:

If the programmes are doing some good, why is the Fed not expanding them? The outlook has improved, for one thing: America’s economy is levelling out, it noted on August 12th. But the main reason is political, not economic. The Fed’s Treasury-purchase plan prompted charges that it was inviting hyperinflation and had subordinated itself to the government’s deficit needs. Alan Greenspan, a former Fed chairman, says inflation will exceed 10% if the Fed fails to shrink its balance-sheet and raise rates, and 3% for a time even if it does.

Needless to say, that is not the Fed’s view: it still foresees rising unemployment and falling inflation. But many officials have concluded that, for now, the benefits of buying more Treasuries do not outweigh the costs of a damaging rise in inflation expectations and a perceived loss of independence.

I can see why the Fed would decide against printing more money if doing so raised inflation expectations in a harmful manner. But that’s a basic consideration in making monetary policy decisions, and doesn’t really count as “political, not economic”.

So what’s the political consideration here? If second-guessing politicians means that the central bank fails to do something it would otherwise have done, then that central bank has lost independence. If the Fed’s doing what the politicians want, it has lost independence already. So what’s it worried about?

I think that what Ip is trying to say is that central banks have a lot of independence so long as inflation expectations are low, but if they’re perceived to have lost their grip on inflation, then that perceived independence can evaporate very quickly. (This is all about perceptions, interestingly enough: inflation expectations, rather than actual inflation and perceived independence, rather than actual independence.) And so in order to maintain a reputation for independence, they will be inclined to favor the arguments of political hawks. It’s a way of second-guessing themselves into having less independence in reality, just for the sake of keeping more independence in the public mind. Or something.

That said, at the margin, this phenomenon acts in favor of tighter monetary policy, even as politicians generally tend to agitate for looser monetary policy. So maybe these things largely cancel each other out.