Rajan argues that a central bank's independence is not guaranteed by its structure but by the political consensus supporting it. When political polarization increases, institutions like the Fed become vulnerable to pressure, as their supposed autonomy is only as strong as the political will to uphold it.
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The Bank of Japan's decision to hold rates, perceived as politically motivated, causes it to fall further "behind the curve" on inflation. This inaction could erode market confidence to the point where even future hawkish communications are ignored, suggesting the central bank is losing control of the market narrative.
Rajan suggests that a central bank's reluctance to aggressively fight inflation may stem from a fear of being blamed for a potential recession. In a politically charged environment, the institutional risk of becoming the 'fall guy' can subtly influence policy, leading to a more dovish stance than economic data alone would suggest.
The Fed's recent rate cuts, despite strong economic indicators, are seen as a capitulation to political pressure. This suggests the central bank is now functioning as a "political utility" to manage government debt, marking a victory for political influence over its traditional independence.
Former RBI Governor Raghuram Rajan points to a historical pattern preceding every major financial crisis: a U-shape in monetary policy. An extended period of easy money builds up risk, and the subsequent tightening phase triggers the collapse. This framework helps identify periods of heightened systemic vulnerability.
While political pressure on the Federal Reserve is notable, the central bank's shift towards rate cuts is grounded in economic data. Decelerating employment and signs of increasing labor market slack provide a solid, data-driven justification for their policy recalibration, independent of political influence.
While Sanai Takaichi's past comments raised alarms, her statement that government should be "responsible for both fiscal and monetary policy" is consistent with the BOJ Act's coordination requirement. She has since moderated her tone, suggesting the Bank of Japan's path towards rate hikes will likely continue, driven by inflation data rather than political pressure.
'Fiscal dominance' occurs when government spending, not central bank policy, dictates the economy. In this state, the Federal Reserve's actions, like interest rate cuts, become largely ineffective for long-term stability. They can create short-term sentiment shifts but cannot overcome the overwhelming force of massive government deficit spending.
The Bank of Japan's surprising decision to hold rates, despite strong economic data, suggests political factors heavily influenced the outcome. The unchanged inflation outlook and a repeat 7-2 vote split indicate that policy is not being guided solely by fundamentals, a crucial consideration for predicting future moves.
As governments print money, asset values rise while wages stagnate, dramatically increasing wealth inequality. This economic divergence is the primary source of the bitterness, anxiety, and societal infighting that manifests as extreme political polarization. The problem is economic at its core.
In periods of 'fiscal dominance,' where government debt and deficits are high, a central bank's independence inevitably erodes. Its primary function shifts from controlling inflation to ensuring the government can finance its spending, often through financial repression like yield curve control.
