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Politics seen as main threat to central banks

August 26, 2000

A CENTRAL bank must be allowed to operate without political interference or it will ultimately be forced to set interest rates higher than warranted, said the chairman and president of the Bank for International Settlements, the so-called "central bank for central banks" based in Basel, Switzerland.

Urban Backstrom, also the governor of Sveriges Riksbank, the Swedish central bank, spoke on Thursday at a dinner in Bangkok sponsored by the Bank of Thailand (BOT).

"In order to be successful with the implementation of an inflation-target approach, the central bank must be able to act independently of day-to-day party politics and to set interest rates continuously according to the specified inflation target," said the Swedish-born economist. "Otherwise a credibility problem arises because it will be hard for policymakers to convince the general public of a monetary policy's long-term nature. Lack of credibility, in turn, means that the central bank must set its interest rates higher than otherwise would have been the case."


"Looking ahead in monetary policy is hard when the economy is going through major changes that make it difficult to forecast the future path of the economy and inflation,"

Backstrom praised the BOT's commitment to using monetary policy to maintain inflation in the 0 to 3.5-per-cent range. The Monetary Policy Board's July report, its first to be published, "is very impressive and has given me quite a few new ideas", he said.

Saying he did not believe the central bank could operate in a void, former prime minister Anand Panyarachun asked Backstrom to define exactly what he meant by "independence".

Backstrom said the central bank must operate as a part of the democratic system. It must be given independence in its daily operations, while working toward the policy objectives of the government. If politicians don't agree with its actions, they can pass legislation to set new policy objectives. Backstrom said that governments' must provide legislative support to ensure the central bank's independence.

An amendment to the Bank of Thailand Act would have given the BOT that independence, but its passage has been stalled by the winding down of the Chuan administration.

BOT governor MR Chatu Mongol Sonakul has pressed forward anyway, forming the Monetary Policy Board to manage inflation. Backstrom also talked about how monetary policy should react to changes in the prices of assets such as equity or real estate. He said asset prices must be seriously considered in the management of inflation. Increases in asset prices are reflected in higher stock prices, increased household wealth and eventually aggregate demand.

Consumer confidence boosted by higher share prices could make individuals more prone to spend their increased wealth, he said.

"If the asset prices on which households and firms base their consumption and investment decisions prove to be too optimistic, this would create inflationary pressure in the short term. An important question in this context is how sensitive households' and firms' consumption and investment responses are to changes in asset prices," he said.

Monetary policy must distinguish between the asset-price increases driven by productivity and expectations of higher future profits, and those that are not supported by fundamental economic conditions, he said.

Increases in asset prices that are not supported by economic fundamentals will inevitably burst, and it is the central bank's task to ensure that that doesn't happen, he said.

Monetary policy also should address structural changes in the economy, Backstrom said. Most of the talk about monetary and productivity growth in the United States is the result of the impressive economic performance there, he said.

Higher productivity poses challenges because it could affect aggregate supply and demand, inflation, equity prices and interest rates, he said. It is necessary for the central bank to distinguish structural changes from cyclical variations. Another challenge is to deflect the magnitude of the effects.

"Looking ahead in monetary policy is hard when the economy is going through major changes that make it difficult to forecast the future path of the economy and inflation," Backstrom said.




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