It is worth questioning the dictum that central banks should occupy their own autonomous policy space.
During Congressional testimony in February, Republican Senator Joe Kennedy tried to pin U.S. Federal Reserve Chairman Jerome Powell down on whether or not he supported the $1.9 trillion stimulus plan. Powell responded: “On every public occasion when I’ve been asked about it, I’ve said that it’s not appropriate for the Fed to be playing a role in these fiscal discussions about particular provisions in particular laws.” Throughout the hearing, he dug a moat around the bank’s narrow price stability mandate and refused to comment directly on anything that might fall outside of it.
This separation of fiscal and monetary policy also featured in a heated discussion in Indonesia several months ago. During the Asian Financial Crisis, the collapse of the rupiah plunged Indonesia into a balance of payments crisis and subsequent IMF-led reforms formalized the policy independence of Bank Indonesia. This was intended to insulate the country’s central bank from political influence as it carried out its mandate to keep the currency stable.
But in late 2020, on the heels of a controversial omnibus bill that expands centralized state power in the name of economic development, a proposal was floated to establish more direct government control over monetary policy. Many commenters were quick to characterize the effort as an attack on the independence of the central bank, and framed it as a negative that would shake market confidence and lead to the looting of public coffers. Under such blowback, the proposal was shelved.
But why should central banks be walled off in their own autonomous policy space in the first place? Why shouldn’t monetary and fiscal policy be actively coordinated? Why must central bankers like Jerome Powell pretend they have no opinion on enormous fiscal stimulus packages or tax cuts? The rise of monetary at the expense of fiscal policy reflects the victory of Milton Friedman’s monetarist philosophy that economic activity is best regulated through simple and neutral policy tools like the rate of interest.
Essentially, monetarists believe that there is one, or maybe several, natural rates of interest, the rate at which economic growth can be maximized with stable inflation. Because this is believed by some to be a natural but unobservable threshold, it naturally follows that setting interest rates is best left to a neutral arbiter who will manage policy in a clinical manner. This is why central banks have become increasingly independent from the supposedly dirtier political skulduggery of fiscal policy, left to their own technocratic devices to chase the perfect interest rate in equilibrium. In emerging markets like Indonesia, the goal is usually to use these same neutral policy tools to dial in an…