Comparative Central Banking and the Politics of Monetary Policy: The Relationship Between Governments and Central Banks Must be Balanced and Defined

Business Economics, Oct, 2001 by Laurence Meyer

The change in views about the role of tax-rate and spending adjustments as part of an activist stabilization policy significantly diminished any need for ongoing coordination between monetary and fiscal policies. The main issues of coordination in recent years have been about how monetary policy should adapt to significant shifts in the direction of fiscal policy, which are motivated in turn by the longer-run considerations. Recent examples include the monetary policy responses to the Clinton Administration's deficit reduction direction and, going forward, to the Bush Administration's longer-run fiscal program. I have described this kind of coordination as sequential decisionmaking. Fiscal policy is slower moving. Once fiscal policy is decided upon, the Fed takes that policy into account (and/or takes into account its expectations of future fiscal policies) when it sets monetary policy. However, if fiscal policy wanted to play a more important role in active stabilization policy, the potential for tension bet ween the administration and the Congress and the Fed could increase, especially at times when the fiscal, and monetary authorities have different views about the cyclical situation or if they have different objectives.

The relationship between the Fed and the executive branch was exceptional during the Clinton Administration. Early indications point to a continued excellent relationship with the new Bush Administration. In contrast, the recent relationship between the Bank of Japan and the rest of the Japanese government seems not to have been so good. This undoubtedly reflects in part the fact that the Bank of Japan and the Ministry of Finance are still working out their respective roles following the Bank gaining greater independence. An interesting question, however, is whether the tensions have affected policy outcomes and macroeconomic performance. It sometimes appears that the result has been a stalemate or the outcome of a noncooperative game.

For example, has the Bank of Japan been reluctant to engage in bolder monetization strategy in part because of differences in policy priorities and tensions with the Ministry of Finance? The Bank of Japan seems to believe that operations in longer-term government bonds reduce the incentive of the government to move toward fiscal consolidation. Therefore, monetary policy in Japan might be affected not only by views about how such policies would affect macroeconomic performance for given fiscal policies, but also by views about how fiscal policy might adjust to monetary policy. Another way to pursue more stimulative policy, even once the nominal policy rate is driven to zero, might be to carry out open market operations in foreign bonds--in effect, unsterilized foreign exchange intervention. But foreign exchange intervention is at the discretion of the Ministry of Finance, not the Bank of Japan, so this direction might at least give the appearance of ceding control of the timing and magnitude of monetary policy actions to the Ministry of Finance. Such an appearance would be a problem even under the best of relationships, but such a direction may be still less likely when there are tensions between the two parties and when the independence of the central bank is so recent. Finally, the Bank of Japan may believe that there are limits to what monetary policy alone can accomplish and, given the uncertainty about the effects of monetization, may resist moving in this direction until the government moves decisively to deal with banking problems and the overhang of corporate debt and moves more boldly to open markets to domestic and international competition.