The creeping politicisation of central banks: What it means for fixed income investing

The ‘politicisation’ of central banks is more than just an awkward word to pronounce. It reflects a growing political pressure on central banks caused by an evolving macroeconomic and political backdrop. At a recent dinner attended by policy experts, we discussed the changes that have taken place and how this might affect fixed income markets.

Independence under pressure

Central bank governors operate under difficult conditions. Operational independence means they are expected to resist political demands and maintain discipline, even at the cost of popularity. The notion that policymakers should “remove the punchbowl” during periods of economic exuberance reflects the uncomfortable but necessary role they play. In recent years, a combination of economic crises means political scrutiny has intensified and expectations have broadened.

It is worth remembering that central bank independence has not always existed. Until 1997, the Chancellor of the Exchequer in the UK set the main policy interest rate, with the Bank of England playing an advisory role. Even in the US (seen as a bastion of independence), there were flaws: Tapes recorded in the early 1970s between Federal Reserve (Fed) Chair Arthur Burns and President Nixon revealed pressure on how the Fed might aid the economy and ultimately support President Nixon.

Rather than overtly directing policy decisions, governments increasingly shape outcomes through appointments and subtle changes to mandates. Appointing individuals perceived as more ‘agreeable’ represents a relatively straightforward route to influence, albeit one that risks undermining institutional credibility.

Soft power

Central bank mandates lie at the core of their independence, yet they also represent a channel for political intervention. Governments can either constrain central banks by limiting their powers or by expanding their responsibilities to create dependencies. Adding objectives such as supporting employment, financing programmes, or addressing inequalities may appear constructive, but can blur institutional boundaries and expose central banks to political expectation.

There is also a structural bias towards looser monetary policy. Political cycles naturally favour accommodative conditions – politicians would prefer low interest rates to stimulate an economy ahead of elections and would equally like low rates during periods of economic stress. When central banks appear to align with such preferences, markets may incorporate an implicit risk premium, reflecting doubts about their independence.

A post-crisis shift

It has become something of a cliché to blame the Global Financial Crisis for ongoing ills, but the fact is that it marked a major turning point in central banking.

The scale and urgency of the response, notably through quantitative easing (QE) and liquidity provision, expanded the perceived capabilities of monetary policy. What began as emergency measures became, over time, standard tools. Central bank balance sheets swelled.

What is more, the shift altered thinking within governments. If central banks could stabilise financial systems, support growth, and prevent deflation, then why not use these tools more broadly? In some cases, this fostered overconfidence in the ease of managing inflation and the belief that monetary policy could be aligned more closely with political priorities. Witness the growing advocacy for Modern Monetary Theory (MMT) during the COVID pandemic era, although support for MMT has since dwindled following the recent bout of inflation.

Monetary policy began to substitute for fiscal policy. Central banks were often looked on to provide stimulus, while governments avoided the more politically contentious fiscal measures (more government spending meant more borrowing or taxation). This imbalance reinforced the perception that central banks could carry a disproportionate share of economic stabilisation, further entangling them with political decision-making.

Market counterbalance

Despite these pressures, financial markets retain some degree of disciplining power. Episodes of sharp repricing, driven by concerns over fiscal sustainability or policy missteps, can quickly force a recalibration. The “mini-budget crisis” under former UK Prime Minister Liz Truss or the pushback on tariffs show how markets can seek to undo or dilute policy they see as incoherent or dislike.

In this sense, markets act as a ‘self-righting mechanism,’ albeit an imperfect one. They can signal limits to policy experimentation, although a reliance on market discipline is inherently reactive and can introduce volatility.

Sovereign borrowing costs are influenced not only by inflation and growth expectations but also by perceptions of institutional integrity. The degree of central bank independence, while difficult to quantify, forms part of the broader risk assessment applied by investors.

Is inflation targeting too narrow?

While inflation targets remain a central anchor, they have often been applied narrowly, focusing on consumer prices while overlooking broader financial metrics such as asset inflation and credit conditions. For example, much of the economic comment about inflation is devoted to energy cost inputs but we see pressure also coming from capex spending, where demand is inelastic and less price sensitive.

Monetary policy alone is a blunt tool. In crises, central banks can act quickly so it makes sense that they should be used as a first phase of response (whether lowering or raising rates or injecting liquidity) but it is better if a fiscal response then takes over (government spending or austerity). If stimulus is fiscal, and less monetary, it arguably improves the yield curve and lowers wealth inequality. Inflation targeting therefore needs to be supported by a mix of policy instruments.

Coordination in a fragmented global order

Central banks operated cohesively in an era when global policy coordination, US leadership, and multilateral institutions provided a relatively stable economic environment. While the International Monetary Fund and World Bank remain important, their authority is now being challenged by a more fragmented geopolitical landscape. States increasingly view sanctions, reserve management, and payment systems through a competitive lens.

This alters the rubric for central bank coordination. It has also undermined trust in institutions, in counterparties, the dollar system, and accessibility to global financial plumbing. This is especially relevant in reserve management where there is no simple substitute for the depth and liquidity of US treasuries.

Debt levels as a constraint

The backdrop to these developments is a global economy characterised by elevated debt levels and constrained fiscal flexibility. In such an environment, monetary policy decisions carry significant distributional consequences, influencing asset prices, income inequality, and financial stability. Central banks are therefore operating in a context where their actions are inherently political.

More worryingly, the capacity to respond to future crises may be more limited than in the past. Entering a downturn with high debt levels reduces fiscal ‘wriggle room’ and increases reliance on monetary policy, reinforcing the cycle of dependence and politicisation.

Resolving the tension

It is hard to see the tension between independence and political influence being resolved. For now, we probably need to accept that an element of risk premium is built into sovereign spreads. The cost of capital, more broadly, is higher in response. Kevin Warsh, the new Fed Chair, remains something of an enigma. We expect him to quieten the influence of the Fed Board and wider messaging, which in turn places more emphasis on economic data. In such an environment, duration becomes an even more important consideration. A potential hedge to interest rate uncertainty is to consider short-dated income assets or securitised areas such as Collateralised Loan Obligations (CLOs) that have a more floating rate structure.

From a credit perspective we need to be mindful of borrowing levels but equally cognisant that companies need to take some financial risk because if they do not, they have a business risk. Chief Investment Officers can be damaged by the right decision at the wrong time, i.e. being too conservative too early and allowing other companies to take market share. There is a lot of energy in the markets right now around artificial intelligence (AI) but we think investors should be selective, looking beyond some of the hyperscalers towards areas that potentially offer better risk-adjusted value or are involved in areas that are helping to relieve bottlenecks in the AI build-out.

Regardless of the degree of central bank independence, there will ultimately come a time when the central bank needs to remove the proverbial punchbowl and investors want to be on the right side of that when it comes.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Securitized products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.