As the gatekeepers of a country’s fiscal policies, central banks play an essential role in stabilizing their local economy. The list of central bank responsibilities runs long, but in a nutshell, their primary duties include balancing monetary supply and demand, managing credit levels, supervising the growth of financial institutions and controlling interest rates. Proper management of these functions fosters economic growth and creates stability in the country.
Fulfilling these obligations is the type of balancing act that requires extra care, and a firm grasp on the rudiments that make up a healthy economy. Sometimes, however, a cautious fiscal mandate clashes with the reigning government’s agenda; if the monetary policy is set by branches of the government, the economy’s stability could be at risk. Thanks to checks and balances in democracies, devious leaders rarely get away with attempts to undermine sensible economic policies as a way to appeal to voters or promote a personal agenda. In certain third world countries however, a country’s fiscal policy is often sacrificed by leaders who have a myopic way of thinking. Jameel Ahmad, VP corporate development and market research at FXTM, says: “there are many examples of economies damaged by meddling leaders and their political aspirations, which go against the economic status quo. An incumbent may put pressure on their central bank to reduce interest rates during election time, because this may increase disposable income, boost economic growth and decrease unemployment – scenarios that would help the incumbent get re-elected.
However, these are short-lived gains because the haphazard act of loosening a country’s monetary policy can cause the economy to grow faster and increase inflation, even to a point where it spirals out of control. Despite the negativity associated with politicians trying to exert undue influence on monetary policy, it is a common occurrence.” Raghuram Rajan, the governor of the Reserve Bank of India, was recently squeezed out of his job by politicians belonging to the ruling Bharatiya Janata Party party. In July 2017, the African National Congress, South Africa’s ruling party, proposed that the South African Reserve Bank be nationalized. As soon as the news hit, the rand predictably fell, by around 1.5%, to R13.45 against the U.S dollar. While Finance Minister Malusi Gigaba keeps saying all the right things aimed at protecting the independence of the Reserve Bank, a sinister undertone may be implied. Nationalization will, by its very nature, give the government more influence over policies.
Politicians like the money supply to increase before elections because a reduction in interest rates stimulates economic activity; consumers increase borrowing and consumption. Businesses borrow more to invest in production, and employment figures start to look more attractive. However, this kind of economic stimulus precipitates inflation. Eventually, the economy goes into reverse, and there is a reduction in the money supply, while interest rates increase.
The mandate of a central bank is materially linked to a country’s economic progress but they do not always rise to the challenge. Perhaps the most spectacular example is Venezuela’s central bank, which can only be described as a catastrophe. The weakening economy of Venezuela, under the regime of President Nicolas Maduro, is forecast by the International Monetary Fund (IMF) to reach a consumer-price inflation rate of a massive 1,640% by the end of 2017. This has been, in part, precipitated by the disastrous management of the central bank by Nelson Merentes, who recently was asked to step down as governor. The impact on the economy includes shortages of food staples such as milk, flour, and it has also resulted in medicinal shortages, electricity cuts, rising unemployment and a noticeable increase in crime.
In recent years, there has been an increasing trend to give monetary policy decisions to independent central banks. Countries that do this tend to fare better, according to research. In addition to making more measured economic decisions, a country with an independent monetary policy garners more credibility, which in turn earns more confidence from the international community. In and of itself, this helps maintain the favor of citizens, investors and ratings agencies.
“Central bank independence is a widely accepted practice today. Perhaps the bigger issue is whether they should wait for inflation to take hold before they act, or act when they see the first signs. Interest rates are good indicators of the health of an economy. Ideally, they should be allowed to rise and fall naturally as the economy expands or contracts, and they should not be influenced by political agendas,” says Ahmad. As independent as they are, central banks will always be accountable to their masters, walking the fine line of holding onto independence while trying not to invoke the wrath of the institution that can pull the rug – the government.