Formal central bank independence is increasingly under pressure as societal preferences for a lender of last resort savior grow ever stronger (and more priced into nominal risk markets) as do demands for politicizing the monetary authorities under the pretext that they should more politically independent. Morgan Stanley takes on the question of constitutionality among the G3 Central Banks and rather unsurprisingly finds the mandates, targets, and prohibition treaties to be 'flexible' at best and 'practically meaningless' at worst. We-the-people appear to have little if any remit to constrain - even if our collective call for more printing leads to 'be careful what you wish for' reactions, as Michael Cembalest noted yesterday, "first prize in the Central Bank balance sheet expansion race is not necessarily one you want to win".
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G3 Central Banks: Constitutional Questions
Morgan Stanley Global Economics Team
If societal preferences towards inflation were to change, central bank constitutions would likely be flexible enough to accommodate this – formal central bank independence notwithstanding.
In addition, changing central bank constitutions does not run into insurmountable institutional hurdles (with the possible exception of the ECB).
The prohibition to buy government debt at auction enshrined in central bank constitutions is practically almost meaningless, given that monetary authorities naturally buy in the secondary market.
The prohibition to buy at auction for the ECB is not more stringently worded than for the Fed or the BoJ. While from an economics perspective the ability to buy in the secondary market is practically sufficient for the ECB to play a de facto lender of last resort role, legal complications may arise if the treaty is interpreted as prohibiting a de jure lender of last resort role.
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A de facto LOLR role can be performed effectively even with the legal prohibition for buying at auction in place.
In this case, it is the fact that at least part of the Governing Council is reluctant for the ECB to assume even a de facto LOLR role that differentiates it from its central bank peers in the eyes of the market. While the reasons for this reluctance are sound, this attitude can be a double-edged sword. Eurozone governments issue liabilities in a currency they cannot themselves print. Much like banks, that makes them vulnerable to a self-fulfilling run, and in part it is to prevent such runs that central banks were historically created: to provide a lender of last resort. As we have said in the past, even if a fiscal union was in place in the eurozone, a resolution of the crisis would likely still require the ECB to be able to act as a de facto LOLR for governments.
Conclusions
While there are subtle differences across central banks’ mandates, the universal “price stability” mandate is inevitably very broad. While the operational definitions of price stability are specified by the monetary authorities themselves, they are not immutable (and in any case the vague time horizons allow very sustained deviations from target, as the case of the BoJ demonstrates). Further, changing the central bank constitutions themselves appears – with the exception of the ECB – not excessively difficult. In short, there is nothing hard-wired into central bank legislation that would prevent at least moderately higher inflation in the medium term. Soft constraints – i.e., the importance central bankers attach to their hard-earned credibility – may be more important.
The prohibition to buy at auction exists across the board but is practically not a very meaningful constraint on government financing, since the ability exists to buy in the secondary market.
Economically, this implies that a central bank could be a de facto lender of last resort to sovereigns even if it is de jure banned from buying at auction. In the case of the ECB, the legal prohibition of monetary financing is very similar to the prohibition the Fed and the BoJ face: it applies to primary market purchases only; and it seems not more stringently worded. While from an economics perspective the ability to buy in the secondary market is practically sufficient for the ECB to perform a de facto LOLR role for eurozone sovereigns, legal complications may arise if the treaty is interpreted as prohibiting a de jure LOLR.