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The writer is a former president of the World Bank
This year macroeconomists and market mavens alike have been making mistaken guesses about the interest rate calls of major central banks. The masters of finance need to add another element to their forecasts: institutional politics.
Neither the US Federal Reserve’s Jay Powell nor the European Central Bank’s Christine Lagarde is a certified member of the central bankers’ club. Lacking the economics training and record, they must operate as deft chairs of technocratic boards. Their predecessors — notably Paul Volcker, Alan Greenspan, Ben Bernanke and Mario Draghi — earned the respect of the monetary priesthood; they could debate with the experts and steer policies based on their own backgrounds. Powell and Lagarde cannot.
As a result, the Fed chair and ECB president are especially reliant on staff forecasts. But these models have not been working well. The resulting uncertainty has created more room for a range of opinions from the bank boards, but not increased authority for the principals. The institutional counter to this drift has been to rely on a supposedly refined, technical approach: “data dependence” — a term that means central bankers don’t know what to do.
This creates complications. Powell, Lagarde and their colleagues are highly dependent on monthly releases, which are often preliminary, flawed and even contradictory. In addition, monetary policy operates with lags, probably of about nine months to over a year, so today’s data is an uncertain guide for policy.
Consider how these conditions create institutional constraints. It seems probable that Powell would like to cut rates, both to confirm his record after misjudging the inflationary surge and to give a boost to President Joe Biden. Of course Powell will stress that the Fed is apolitical, but he knows that Donald Trump, the presumptive Republican candidate, wants to fire him and run roughshod over the independence of the central bank. But Powell cannot override the monthly data even if he believes future conditions would benefit from a rate cut.
Lagarde played her political hand differently, but has further limited her room for manoeuvre. She wrapped herself in a European flag, asserting months ago that the ECB did not need to follow the Fed. But her forward guidance pitted her credibility against data that suggested lingering inflation. Now she will find it difficult to cut again because of signals that prices may turn upwards.
Powell and Lagarde will try their best to work within these institutional boundaries. Yet market watchers need to recognise that the politics of institutions are just as important as their macroeconomic and monetary models — if not more so. In particular, investors should be alert to possible challenges to the institutional culture of central banks in 2025.
Trump has few policy principles, but the ones he does assert would spark a revival of inflation. Like any real estate developer, he always wants lower interest rates regardless of current levels, and he sees no reason to let Powell and the Fed get in his way. If he were to combine demands for rate cuts with an assault on the Fed and a broad-based tariff increase — and call to weaken the dollar — central bank credibility and effectiveness would crumble. The battle in 2025 over expiring tax cuts worth an estimated $4tn of revenue over the next decade will add to Fed worries. If the Fed loses control of inflation, the effects on the dollar, interest rates and trade would plague central banks around the world.
During the 1970s, the Fed faced a fundamental institutional challenge. Chair Arthur Burns tried to adapt to political pressures, but left only a legacy of out-of-control inflation, vulnerability to shocks, and a weaker institution. Volcker chose a different path, becoming a model for courageous central bankers. Many people in markets today may not recall Burns’ story, but recent experience has reminded both political leaders and central bankers that voters do not like inflation. Prudent forecasters will need to study the institutional politics of central banks, as well as monetary theories and models.
