Is Politics Dominating Central Banks Now?

The practice of central banking involves a good deal of guesswork on behalf of economists.  When one combines economists’ guesswork with interested elected representatives, one gets a fascinating dynamic whereby there’s a constant push and pull on monetary policy.  There was a time, not long ago, when economists fiercely defended the idea of a politically independent central bank.  American economists, in particular, have always had a dislike of the idea that interest rates are influenced by political conditions. Considering what’s happened in the central banking capitols of the world – the United States and Europe – over the past ten years, does anyone really believe in the political independence idea anymore? Besides perhaps chagrining bureaucratic economists displeased by the very mention of a politically subservient central bank, the answer is probably no.

Here’s a look at what the Federal Reserve has done with its Federal Funds target rate over the past six loosening cycles.  The title of each colored line represents the year in which the loosening began.  The vertical axis is the average Federal Funds target rate by day.  The horizontal axis is the number of days the given loosening has been going on.

Likely no surprise to any financial market observer, the 2007 loosening cycle is the longest on record at over 2,400 days.  The loosening cycle will surpass seven years this August.  The previously longest cycle? The loosening cycle that began in 1989, lasting over 1,700 days (over four years).  Conversely, the shortest loosening cycle on record was in 1980, lasting less than 100 days.

In looking at the chart, it’s readily apparent that the length of loosening cycles has increased over time.  In addition to the lengthening of the loosening cycle, the volatility of the Federal Funds rate has also gone down, as has the height the Federal Funds rate reaches.

If you’re a politician, what do you want from your central banker?

You likely want three things. First, you want cheap money.  That’s certainly the trend over the past 70 years. Second, you want a consistent, non-volatile Federal Funds target rate.  In looking at the figure, it’s generally clear that central bankers have complied with this desire. Third, you want the cheap money to last a long time.  Unsurprisingly, central bankers have given in on this desire as well.

Let’s shift to the tightening cycles and see if that corresponds to what elected representatives would want.

In this case, an elected representative would want three similar things from his central banker. First, you’d want the tightenings to be less tight.  That’s happened. Second, you’d want central banking to be non-volatile.  That’s happened. Third, you’d want tightening cycles to be short.  This, however, has not happened.

Overall, in looking at the nature of movements in the Federal Funds rate, it certainly appears that Federal Reserve officials are aligning their actions with the desires of elected officials.  When it comes to the current loosening cycle, the behavior of the central bankers is quite pronounced this time around.