Central Banks Face Rising Pressure From Politicians

(Update2)

By Simon Kennedy and Matthew Benjamin

Feb. 19 (Bloomberg) -- When politicians tried to pressure former European Central Bank President Wim Duisenberg, he used to say: ``I hear, but I do not listen.'' These days, a growing number of central bankers worldwide are hearing a lot -- and some are listening.

The Bank of Japan refrained from raising interest rates last month in the wake of government pressure. The autonomy of banks from Ecuador to India is under attack. French presidential candidates are demanding the ECB meet a goal for growth.

``Political pressure is definitely intensifying,'' says Stephen Roach, chief economist at Morgan Stanley in New York.

The central bankers under the gun have already helped deliver the strongest global expansion in 30 years and kept a lid on prices. If they wind up running ``politically compromised monetary policies,'' Roach predicts, ``ultimately, you'll get more inflation.''

While lobbying central banks is one thing, meddling is another, says former Fed Governor Laurence Meyer. ``The danger here is to inflation expectations,'' says Meyer, Washington- based vice chairman of Macroeconomic Advisers LLC. ``Market participants will have less confidence in central-bank independence in the face of political pressure.''

The Bank of Japan's standing has already suffered in financial markets after Governor Toshihiko Fukui and fellow policy makers unexpectedly left the benchmark rate unchanged at 0.25 percent last month. That came after Chief Cabinet Secretary Yasuhisa Shiozaki and other officials said the bank should consider the government's view when setting rates.

Indirect Pressure

``The government has been putting indirect pressure on the bank not to raise rates,'' says Yasunari Ueno, chief market economist at Mizuho Securities Co. in Tokyo. Shiozaki repeated his advice last week, and Vice Finance Minister Hideto Fujii urged the bank to support economic recovery.

The perception that politics may be playing a role in monetary policy leaves traders in doubt about what the bank will do this week, says Peter Morgan, chief Asia-Pacific economist at HSBC Holdings Plc in Hong Kong.

Interest-rate swaps suggest a 61 percent chance of an increase, according to Credit Suisse Group. Before the bank surprised investors by leaving rates unchanged last month, traders saw as much as an 80 percent chance of an increase at January's meeting.

`Confusion'

``There's a fair degree of confusion now,'' says Morgan. ``The bank has denied it, but it's hard to eliminate the suspicion there was some political pressure and that it's still in place.''

Monetary policy is becoming especially politicized in economies without a strong tradition of central-bank independence. In Europe, the central banks of Slovenia, which joined the euro last month, and Poland have become embroiled in political disputes over who should run them.

Brazilian President Luiz Inacio Lula da Silva's advisers argue his push to quicken growth is hampered by the policies of central bank head Henrique Meirelles. Ecuador's central bank last month took out newspaper advertisements defending its autonomy after President Rafael Correa questioned the need for its independence. Venezuela's President Hugo Chavez is also extending his control over its central bank.

In Asia, Thailand's central bank now reports to military leaders who won power in a September coup. Indian Finance Minister Palaniappan Chidambaram this month urged banks not to raise mortgage rates, putting him in conflict with Reserve Bank Governor Y. V. Reddy's effort to slow the economy with higher borrowing costs.

Intensified Pressure

Julian Jessop, chief international economist at Capital Economics Ltd. in London, says if political heat is building at a time of strong global growth, it will only intensify when the economy weakens. ``The fear of politicians is that the boom will be brought to an end by aggressive central banks,'' he says.

Feeding those worries is a perception that the expansion has boosted asset values and corporate profits without providing similar benefits to workers, says Roach. Among the Group of Seven major industrialized countries, labor's share of national income shrank to a record-low 54 percent last year, while the share going to profits rose to 16 percent from 10 percent five years ago, he calculates.

Those pressures are currently on display in Europe, where the ECB is under fire as it signals plans to raise its benchmark rate from its current five-year high of 3.5 percent. But while French presidential candidates Segolene Royal and Nicolas Sarkozy both want the bank to meet a goal for growth as well as inflation, ECB President Jean-Claude Trichet is better insulated from such pressures than are other central bankers.

Diffused Power

Power over the ECB is diffused among the 27 nations that constitute the European Union. It would require all 27 to renegotiate the 1992 Maastricht Treaty that created the ECB and set its goals. German Chancellor Angela Merkel said Jan. 30 she supports ECB independence ``with all my strength.''

That hasn't stopped politicians from seeking other routes to influence monetary policy. Luxembourg Finance Minister Jean- Claude Juncker and his euro-area counterparts have been pursuing a bigger role alongside the ECB in managing the exchange rate. That would make it difficult for the ECB to raise rates if the finance ministers were trying to weaken the euro.

Even the U.S. Federal Reserve, with its established tradition of independence, isn't immune; one casualty may be Chairman Ben S. Bernanke's goal of establishing an inflation target, says Alan Blinder, former Fed vice chairman and now an economics professor at Princeton University.

Democratic Hostility

``It's possible that Democratic hostility to inflation targets will cause Bernanke to put the goal of an inflation target on hold,'' he says.

While Bernanke said at his Senate confirmation hearings last year that he thinks the Fed could adopt a target on its own, he has also has said he would ``vet'' any such shift with congressional committees that oversee the central bank. The new Democratic chairman of the House Financial Services Committee, Barney Frank of Massachusetts, says he's leery of any change that might compromise the Fed's dual mandate of seeking both stable prices and maximum employment.

``That's not going to happen when we're in power,'' he told an audience at the National Press Club in Washington on Jan. 3. ``And we can prevent that from happening.'' Frank told Bernanke at a hearing last week that he wants to be ``kept involved'' with the Fed's decision-making.

``There are people in this country who think the Fed somehow should be above democracy,'' says Frank. ``God forbid that anybody in elected office should talk about whether or not we need a 25-basis-point increase in the Fed. Somehow, that's sacrosanct. No, it isn't: It's public policy.''

Harvard University's Kenneth Rogoff, former chief economist at the International Monetary Fund, says that's an important point for central bankers keep in mind. ``Central banks need to earn their independence every day,'' he says.

To contact the reporters on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net ; Matthew Benjamin in Washington at mbenjamin2@bloomberg.net .

Last Updated: February 19, 2007 04:02 EST

Fed has lost control over interest rates

Jubak's Journal12/5/2006 12:00 AM ET

By Jim Jubak

Squeezed by a possible recession and a troubled currency, the Federal Reserve will have to side with the world's bankers and the billions of dollars they hold.

Last week the world called the tune, and the U.S. dollar danced.

The dollar's tumble and Federal Reserve Chairman Ben Bernanke's attempts to placate overseas investors are the clearest signs to date that the foreign investors who finance the huge U.S. trade deficit have gained significant control over the U.S. economy.

A few more weeks like that, and it will be clear to everyone outside of Washington that the Fed has lost control over U.S. interest rates.

Here's what happened:

On Nov. 28, as the dollar edged toward freefall against the euro, hitting a 20-month low against that currency and plunging below key support prices in the currency markets, Bernanke got up on the ol' soapbox to say that inflation was still "uncomfortably high," growth in the economy was solid and the Fed's next decision would be whether to raise interest rates again.

That came as a big surprise to financial markets that were anticipating a cut in interest rates, perhaps as early as the first half of 2007. Just that morning the markets had, in fact, received confirmation of their view when durable-goods orders, an important gauge of the health of the economy, fell by 8.3%. That's the biggest drop since July 2000 and well above the 5% decline Wall Street had expected.

Bernanke's words didn't stop the carnage: Without some proof that the economy was as strong as the Fed said it was, the markets simply tossed off the Fed chairman's comments as a transparent attempt to talk up the dollar. It didn't help that new Treasury Secretary Henry Paulson was out -- predictably -- trying to talk up the dollar at the same time.

The dollar didn't stabilize until the next day, when revised figures on third-quarter gross domestic product showed the economy growing by 2.2%, rather than the 1.6% rate in earlier data. That was stronger growth than the 1.8% that financial markets had expected and provided enough credibility to Bernanke's remarks to push the dollar up 0.3% for the day.

Why the dollar isn't out of the woods

The dollar faces three big problems, none likely to go away quickly:

• There's that whopping U.S. trade deficit. Even though lower oil prices led to a drop in the September trade deficit to a mere $64 billion from the August record of $69 billion, it is on track to break $750 billion this year. That deficit has to be balanced by cash flows from overseas investors who provide the extra money that we spend to buy foreign goods and services. This puts more dollars in the hands of overseas investors and central banks who are already worried about what to do with the dollars they hold.
• Second, there's the slowing of the U.S. economy in 2007. Yes, the revised third-quarter GDP growth at 2.2% was good news, but the economy is still in slowdown mode; second-quarter growth was 2.6%, after all. There's a good likelihood that U.S. growth will lag growth in Europe and Japan for at least the first half of 2007.

Video on MSN Money: Jubak's Journal

As the U.S. dollar continues to take a hit around the globe, MSN Money's Jim Jubak suggests gold stocks, among other options, to counterbalance your portfolio. Click here to play the video.

• Third, U.S. interest rates aren't headed any higher at a time when the European Central Bank and the Bank of Japan are still raising rates. That will lower the yield gap between U.S. interest rates and those in Europe and Japan, and as a result, the price of U.S. notes and bonds is likely to fall, while those issued in euros and yen climb.

Put it all together -- a global dollar glut, a slowing U.S. economy and rising euro and yen yields -- and pressure on the dollar is likely to continue well into 2007. In my opinion, the dollar will stay under pressure until Japan and Europe signal a rate pause, and until the U.S. economy starts to re-accelerate or those of Japan and Europe start to slow.

The long-term implication for interest rates

This week's stumping for a stronger dollar by the Federal Reserve and the Treasury marks a shift of priority for U.S. monetary authorities. Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer not to tank the economy. But Bernanke and company know that the tough choice must be made, managing the dollar is more important at this point than managing inflation or growth.

That's because the huge piles of dollars sitting in the vaults of the central banks of China, Russia, Japan, the OPEC countries and the European Union are large enough that they make overseas bankers nervous. When you hold 700 billion U.S. dollars in reserve (out of a total $1 trillion in foreign-exchange reserves), as the Chinese do, for example, every penny decline in the value of the U.S. dollar makes you nervous, since it represents a drop of $7 billion in the value of your dollar holdings.Sure, there are lots of good reasons to hold dollars and dollar-denominated investments. The yields are higher on U.S. Treasurys and the notes of agencies such as Fannie Mae (FNM, news, msgs). The markets are deeper. The euro is still a relatively untested currency and Japan, the home of the yen, is still crawling, maybe, out of a decade-plus of deflation.

And, most important of all, keeping currencies like the Chinese yuan cheap in relation to the dollar keeps Chinese goods cheap, keeps Chinese exports growing, keeps factories humming and provides new jobs for a restless Chinese population.

Patience has its limits

But that doesn't mean, if you're a central banker in Beijing, Tokyo, Moscow, Riyadh or Frankfurt, that you're willing to sit in dollars forever. Especially if it looks like the dollar will be worth less tomorrow than it is today. Already, Chinese monetary authorities have made it clear that they are putting a smaller percentage of their new foreign-exchange earnings into dollars.

That's a long way from selling dollars, and so far the Chinese are staying in dollars while looking for higher yields than Treasurys pay. But it shows that the Chinese, and the rest of the world's central bankers, are in the midst of an active review of their options.

All it would take for them to exercise one of those options and begin selling dollars would be a conviction that the drop in the dollar is no longer controlled and that the best choice in a bad situation is to sell dollars now before more damage is done to the value of those carefully acquired dollar reserves.

Edging toward the precipice

The Fed knows that the U.S. dollar can rely on the economic self-interest of our biggest trading partners, but it knows that the willingness to hold even a slowly declining dollar created by that self-interest isn't endless, and that continued U.S. trade deficits have eroded that willingness. The dollar is poised on the edge -- maybe not on the very edge but increasingly close to it -- of a very nasty negative feedback loop: a falling dollar leads to dollar selling which leads to a falling dollar which leads to more selling. Once a rush for the exits like that starts, it's hard to stop without some of the players getting badly hurt in the melee.

The U.S. Federal Reserve knows this and is, I believe, determined to head off the possibility of that kind of dollar panic. If strong words about the need for higher interest rates -- blamed on stubborn inflation rather than a global glut of dollars -- will do the trick, all well and good.

If it takes stronger medicine -- an actual increase in U.S. interest rates -- to do the trick, I think the Federal Reserve will raise interest rates, even if the economy is weaker than it would like. The cost of letting a dollar decline turn into a run on the dollar is simply too high. To the Fed, the domestic and, indeed, global damage of a run on the dollar outweighs the purely domestic costs of a period of slow or no growth.

Better now than later?

The choice is easier for the Fed than it would be for you or me. The Fed knows that, once started, the only way to end a dollar panic would be through massive increases in U.S. interest rates. Better to raise rates a little now, even if it creates unemployment and takes a bite out of stock and bond prices, than to face the need to raise rates so high later that it risks sending the U.S. economy into a recession that could be deep enough to take the rest of the global economy with it.

For the Federal Reserve, this dollar scenario moves the focus of policy away from managing domestic interest rates in order to control U.S. inflation and growth in the U.S. economy. The new focus has to be on keeping the overseas investors and bankers who hold so many of our IOUs relatively content with their massive U.S. dollar holdings.

Interest-rate cut less likely

Domestically, an interest-rate cut in 2007 is still on the table. The economy could slow enough so that such stimulus would be appropriate.

But globally, to a Fed that increasingly has its eye on the value of the U.S. dollar, I think an interest-rate cut in 2007 is on the edge of falling off the table. And if the dollar declines a bit more, that option will tumble right off the table. The Fed simply would not have the luxury of putting the domestic economy ahead of the interest of the overseas investors and banks that hold so many U.S. dollars.