It appears as if we are in a new age with respect to the independence of central banks.
During the 1970s and 1980s, everything, it seemed, pointed in the direction of central banks that were independent of political influence that were capable of acting in the overall interest of the public and not of the government.
Since that time, it seems as if interest in maintaining central bank independence has waned and is near all time lows as far as public support is concerned.
And, with a new president in the United States, seemingly willing to take on the policy-making of the Federal Reserve System, and a US Congress in control of a Republican party, that has a growing group of member that seem to want to change the nature and direction of the central bank, the independence of the Federal Reserve appears to be under a significant challenge.
Furthermore, this challenge to central bank independence does not seem to be limited to just the United States.
The argument for independence comes from the fact that central banks have substantial influence over the stock of money that exists in any one economy, and that government's have used money stock inflation many times in the past in order to pay for their expenditures and help them bloat their budgets.
The research of economists have confirmed the relationship between excessive monetary growth and price inflation and this research in the 1960s and 1970s pointed toward a need to separate the control of monetary policy from that of the policy makers that controlled the government's budget in order for a country to achieve more stability in prices.
As Wolfgang Münchau writes in the Financial Times "We should remember that central bank independence is not the natural order of things. Most central banks used to be government agencies until not too long ago, and were subject to political instructions, usually from the finance minister. They became independent after a period of price instability in the 1970s and 1980s produced a consensus in many countries about what a central bank should do."
Over the past 15 years or so, this consensus about the goals of monetary policy has weakened and the support for the independence of central banks has declined.
Not only has the consensus for monetary policy independence fallen, but the role of a central bank's involvement in bank regulation has become entwined with the political forces in most countries. And, this raises a question about whether or not the conduct of monetary policy can really be independent if the regulatory control of the banking system is so connected with the political side of the government.
For example, during the Great Recession and subsequent recovery regulation moved heavily in the direction of keeping banks from failing because of the financial crisis.
In order to support this effort to keep commercial banks afloat, the Federal Reserve entered into three rounds of quantitative easing to help keep banks open. In this, the Federal Reserve is given credit for the masterful job that it did in reducing the number of outright bank failures during this time.
The Federal Reserve policy did keep troubled banks open and allow the other regulatory agencies in the government to smoothly guide the troubled banks into mergers with other, healthy, banks and so minimize any disruptions to the financial system.
One could not say that, in this respect, the Federal Reserve was acting independently of the Congress and of the other regulatory agencies in the political system.
To bring this discussion up-to-date, Mr. Münchau examines the letter recently sent to Fed Chair Janet Yellen from Patrick McHenry, the vice-chairman of the US House of Representatives financial services committee. This letter questions some of the actions of Ms. Yellen and asks whether or not she has the right to do some of the things she is doing, specifically with respect to her authority to "negotiate financial stability rules."
Mr. Münchau closes by saying "The mere fact that a letter such as his was written tells us that the foundations of central bank independence are not as strong as they were."
And, with a potential battle brewing between Ms. Yellen and President Trump over Federal Reserve moves to raise interest rates in the face of Trump's fiscal efforts to stimulate the economy toward faster growth, there is an even greater likelihood that questions over central bank independence will be raised.
In this day and age, things are changing. It appears as if the position of the Federal Reserve within the government structure is going to be tested. This is something we all need to be aware of because changes here will impact the way government policy is made, how the economy will perform, how financial markets will work, and how our investment strategy should change.
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