Supply shock, debt may hurt central bank independence, ex-Fed executive says

By Leika Kihara

TOKYO, May 27 (Reuters) - Pressures on central bank independence are likely to grow as public dissatisfaction over supply-shock-driven inflation may tempt politicians to assign blame to central banks, former Federal Reserve executive Donald Kohn said on Wednesday.

U.S. President Trump's efforts to pressure the Fed may be extreme, but they emerge from broader political and economic developments across many democracies, he added.

Central banks face difficult times as supply shocks, such as the energy crisis caused by the Iran war, complicate their efforts to achieve low, stable inflation, said Kohn, who retains close contact with incumbent policymakers.

Falling real incomes would heighten public dissatisfaction and increase the temptation for political leaders to assign blame to central banks, Kohn said in a speech to a group of Japanese, U.S. and European central bank executives attending a BOJ-hosted conference in Tokyo.

"Ironically, these circumstances strengthen rather than weaken the case for independence," he said in a keynote lecture.

"When inflationary pressures arise from forces beyond monetary policy control, political incentives to demand short-term relief become stronger, even as the need for disciplined policy becomes greater."

An expected increase in already large public debt may also keep interest rates above growth rates for a time, Kohn said, pointing to Trump's call for lower U.S. rates as an effort to control the Fed "in part on budgetary grounds."

An extreme risk would be fiscal dominance - a loss of confidence in the government's ability to manage debt which in turn pressures the central bank to finance public borrowing.

"That is not our current situation, but fiscal pressure can threaten (central bank) independence well before outright fiscal dominance emerges," said Kohn, who is currently a?senior fellow at the Brookings Institution.

"Pressures on independence are likely to grow rather than recede," though central bank independence has endured because experience repeatedly demonstrated its value, he said.

Central banks should protect themselves against attacks on their independence with "discipline, focus, institutional competence, humility about uncertainty, and a willingness to explain difficult choices clearly and candidly," he said.

Clear communication will also enhance credibility, he said, warning central banks against overly relying on economic models.

"Models help organise a complicated world and illuminate historical relationships, but they are simplifications," he said. "In practice, policy making requires something more, a narrative, a disciplined story about what is happening in the economy, what forces are driving outcomes, and how policy can respond."

(Reporting by Leika Kihara; Editing by Lincoln Feast.)