On Thursday, President Trump once again criticized the chair of the Federal Reserve, Jerome H. Powell, blaming the central bank for the U.S. economy’s slowing growth. That’s an echo of his March 2 complaint at a Conservative Political Action Conference, and of quite a few such critiques during 2018, when the president called out the Fed for steadily raising interest rates. And in late 2018, rumors circulated that Trump had been asking whether he could dismiss Powell as chairman after controversially declining to renominate previous chair Janet L. Yellen only a year earlier. Those rumors led Powell to declare on CBS’s “60 Minutes” that he has every intention of serving his four-year term.
While Trump’s open criticism is unusual in its tone and volume, presidential dismay about Fed policy is not. William McChesney Martin, who led the Fed from 1951 to 1970 and was its longest-serving chairman, once called the Fed’s job to “take away the punch bowl just as the party gets going.”
Central banks often hike Interest rates to prevent inflation, distressing politicians who would rather keep rates low, help fuel economic activity, and thereby improve their reelection chances. But our research shows that the more strongly insulated a country’s central bank is from political interference, the less a country has to pay to finance its national debts.
Two recent illustrations
Over the summer and early fall of 2018, investors became weary of the monetary policy in Turkey and Argentina. In both countries, inflation was rising and investors were concerned about their respective central banks’ independence.
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In Turkey, the president shortened the term in office of the central bank governor and deprived the central bank governor of any say in selecting deputy governors. In Argentina, two central bank governors resigned in 2018, signaling policy disagreements with the government.
Quickly investors began selling both the Turkish lira and the Argentine peso. During 2018 both currencies lost about half their value against the dollar, and both countries had to pay significantly higher interest rates to entice investors to purchase their debt.
The United States benefits from a unique position in the global financial system that affords it cheap access to capital. Yet there may be consequences even for the United States from a public brawl between the president and the Fed. So do the anecdotes illustrate anything larger? Are there measurable costs to meddling with the independence of a country’s central bank or firing its head?
How we did our research
We evaluated the economic costs of political interference by asking whether the governance of a country’s central bank influences the nation’s credit ratings assigned by Standard & Poor’s and Moody’s. Credit ratings are important because they affect whether a nation can access capital markets and how much such loans will cost. The higher a country’s credit rating, the stronger the rating agencies’ confidence that the country will be able and willing to repay its debt when it comes due; more confidence generally means a likelihood of a loan at lower rates.
Our empirical analysis uses data from 1973 to 2010 from 78 developed and developing countries. For each country, we measure its credit rating issued by either Moody’s or Standard & Poor’s. We convert the original ratings (AAA, AA, A or Aaa, Aa1, Aa3) into 17-point numeric scales. We measure central bank governance in two distinct ways.
First, we use an index that codes countries’ laws to capture the legal autonomy of central banks to make monetary policy decisions independent from the political needs of governments. This is a well-accepted index that we updated in previously published work. A central bank has more legal independence when the governor’s term in office is longer; the appointment and dismissal procedures are insulated from the government; the bank’s mandate is focused on price stability and the terms on central bank lending to the government are restrictive.
Second, we aim to capture tensions in the relation between the central bank and the government, usually reflected by the dismissal or resignation of the central bank governor or chair. We measured the departure of the head of the central bank before the end of the legal term in office.
Independent central banks improve a country’s credit ratings — and government interference brings those ratings down.
We find strong evidence that greater legal central bank independence improves a country’s credit ratings. For example, in January 2016, Standard & Poor’s lowered its outlook for Poland’s sovereign credit — specifically noting that the governing Law and Justice party was weakening democratic institutions’ independence, including that of Poland’s central bank. Standard & Poor’s, however, raised its outlook in December 2016, when it judged that the governing party was no longer threatening the central bank.
Generally, open conflict about central bank autonomy — as when a government dismisses or prompts the resignation of a central bank’s governor — reduces a nation’s credit ratings. For example, in December 2018, after India’s central bank’s governor resigned, Moody’s warned India’s government to protect the central bank’s independence.
Why does central bank governance matter?
Why do credit rating agencies closely watch how central banks are governed? Good governance serves as a heuristic that reduces uncertainty about the prospects of countries. First, preserving legal central bank independence signals that the government is committed to general macroeconomic stability, including repaying its debt. Second, when the central bank and the government have disagreements major enough to cause resignations or dismissals, investors worry about increased uncertainty surrounding countries’ future policies. Central bank independence tells investors they can expect stable inflation and a predictable monetary policy.
Good governance has long-lasting effects. Dismissing or pushing out a central bank’s head determine rating agencies to immediately downgrade the country’s credit rating. And the negative effect of the central bank’s head irregular replacement will continue to be reflected in a lower credit rating over many years.
In the past four decades, more countries across the globe insulated their central banks from day-to-day politics. But some governments have headed in the other direction, including Hungary, Poland, Thailand, India and South Africa. Our research shows that government interference in monetary policy will be costly.
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No wonder Chairman Powell insists that the Fed does not take politics into account in making decisions about interest rates.
Cristina Bodea is an associate professor of political science at Michigan State University.
Raymond Hicks is project manager of the Columbia University History Lab.