A brief in 750 words
Central Bank independence is held up today as the defining principle of reliable governance
However, independence, which loosens the ties linking a country's Central Bank to its national government, is in fact a quite recent institutional development
With the mandate delivered by their citizens, governments in the old days used to rely on an 'all-inclusive' toolbox of budgetary and fiscal policies.... and of all decisions pertaining to the Central Bank
It is the experience of run-away inflation of the 1970's and 1980's which defined the macro-economic framework under which the Central Banks were legally granted autonomy
Very large interest payments today are the consequence of immense public debts in leading economies, constraining budgetary options
Arbitrage between financial stability and budgetary leeway becomes hard to maintain in a macro-economic setting where the anticipation of inflation is the adjustment variable
The 25% of receipts allocated to interest payments in the U.S. Federal budget (an expenditure >$1.2 trillion with expected annual receipts of $5 trillion) are extreme, but they portend hard choices across financial markets worldwide
In the turmoil surrounding the U.S. Federal Reserve President, J. Powell, inflationary anticipations will almost surely be reevaluated
Expect long-maturity Treasuries to be priced accordingly - our theme of Inverse Treasuries ETFs remains relevant
In practical terms, policies supporting the Central Bank's responsibilities are surprisingly limited in scope to the setting of short-term interest rates
While medium- and long-term rates carry more weight in the economy, the trend in short-term rates, up or down, has become an invaluable macro-economic signal
The short-term interest rate, by advertising the Central Bank's intend to fight inflation or to support economic expansion, exercises a defining influence on the entire yield curve
By setting the rates, the Bank informs the financial markets about a macroeconomic outlook which, in turn, models the all-important inflation anticipations in the economy
This is how Central Banks have come to define their mandate to maintain price stability with a commitment to transparency and accountability
Quite explicitly, independent Central Banks, all over the world, operate under the assumption that price stability is a goal shared by their respective governments
Such a common purpose implies flexibility between financial stability and budgetary policies, with very different timeframes, multi-year in managing monetary anticipations and annual for the budget
If financial stability is subsumed in official political credibility, the interaction between Central Bank and Government will be like a flow of mutually enforcing announcements
Defined in isolation, on a national basis and with recent record of mild price inflation, such an institutional framework used to be credible
However, the challenges that even the largest, rule-setting, Central Banks have confronted make a shambles of such a - very theoretical - "isolation" from comprehensive shocks
The vulnerabilities to the global financial system have been exposed by the Great Financial Crisis (2008-2009)
The Covid-19 emergency and geopolitical conflict have further laid bare major supply-demand imbalances
Under pressure, governments around the world have resorted to public debt for twenty years to paper over very real social tension
Incremental new debt, piled on top of an already consequential entrenched public debt, is by its magnitude a qualitative switch, upending the interaction between Bank and Government
Confrontation has become the byword for normal 'dialogue' with 'independent' central banks around the world, even if the break-up between the U.S. Fed and the Trump Administration alone hits the headlines
The root cause of confrontation is brutally straightforward - in the U.S., interest payments on Treasuries exceeds $1.2 trillion and 25% of Federal budget receipts
This is how Central Bank monetary policy ends up aligning with budgetary imperatives and perhaps becoming subservient to political choice
Cumulative deficits and inexorably growing public debt leave little flexibility to the Central Bank and no freedom of action in the budgetary process
Most developed economies are equally exposed as interest rates trend upwards
In essence, the core issue remains one of trust
Trust of the general public in policies taming inflation
Trust of the bondholders to protect their interests
Trust in the guidance provided by the statistical record of price trends (°)
Without trust, no public administration can exercise credible authority, at least not for a very long time
With trust in all official institutions at a low ebb, and inflation anticipations strengthened by the 'affordability' protests in America, the U.S. dollar (-11% vs the euro over 1 year) and Treasuries are exposed to turbulence
(°) Doubts are creeping in the U.S. inflation statistics (CPI) with the September month-to-month suspicious outlier-plunge of Owners Equivalent of Rent (OER), the biggest component of CPI, weighing 26.4% of the all-items CPI, 33% of core CPI, and 44% of core services CPI, unfixed in October and in November. dragging down annualized CPI for another 9 months... Coincidental perhaps and easy to correct to restore trust - view Wolf Street for details