Central banks’ independence should be cherished

Economic opinion

The recent sharp criticism of the Federal Reserve by US President Trump is the latest instance of attacks worldwide against central banks who act independently when pursuing their policy objectives. Other illustrations of this international trend are the discussion about the role of the Turkish central bank and the close ties of the Bank of Japan with fiscal policy makers in the Abenomics policy framework. However, despite its imperfection, the case for central banks’ independence within their legal mandate remains as strong as ever.

“I think the Fed has gone crazy”. With these remarks, US President Trump openly expressed his disagreement with the latest policy rate hikes by the Fed. Moreover, financial markets temporarily feared that Mr. Trump may actually dismiss Mr Powell as Fed Chair. This public questioning of the Fed’s independence in setting monetary policy has not been an isolated event internationally. In Turkey, the discussion about the role and independence of the central bank has been going on for the past few years. Yet another example is the Bank of Japan, which agreed to closer ties between monetary and fiscal policy when Abenomics started in 2013. By doing so, the Bank of Japan effectively gave up part of its independence in conducting monetary policy.

In most Western economies, the independence of central banks is now taken for granted in the public discussion. The painful inflationary experience of the 1970s significantly contributed to this view. Against the explicit wish of the US administration, former Fed Chair Volcker raised US policy rates sharply in the early 1980s, and successfully brought inflation back under control. This policy example contributed to the growing consensus that central bank independence is the most effective way of achieving medium term price stability.

Consensus being challenged

This consensus is now being questioned. Arguments include the lack of democratic accountability of central bank policy and the substantial social-economic side-effects of the unconventional monetary policy measures in response to the latest financial crisis. For example, a working paper of the Bank of England in 2018 suggested that the overall effect of monetary policy since 2008 on households varied substantially across income and wealth distributions in cash terms.

Finally, the failure of central banks over the past years to reach their inflation targets is occasionally being used as an argument to promote a closer alignment of monetary with fiscal policy, inspired by the Bank of Japan’s current policy approach.

At first sight, these arguments seem to have merits. Moreover, as part of the general government, central banks’ monetary policies and their impacts are indeed not politically neutral, and should as such be subject to public debate. Not all criticisms are, however, related to the concept of central bank independence itself.

The case for central bank independence

Democratic accountability will always remain to some extent at odds with central bank independence. All major central banks try to enhance their accountability by explaining their policy decisions in press communications. This forward guidance and policy transparency play a much more important role than in the pre-financial crisis period. In addition, the reaction of financial markets and their inflation expectations act as an objective assessment of whether the central bank delivers on its policy objective or not.

Criticism of the unintended side-effects of monetary policy is not directly linked to central bank independence as such. Indeed, they would also occur under a democratically elected monetary policy maker.

The argument for closer ties between monetary policy and fiscal policy objectives warrants closer scrutiny. The trend towards more independent central banks since the 1980s was not only driven by empirical evidence, but also by new theoretical insights in the 1970s. The most influential one was Kydland and Prescott’s argument that political authorities who are dependent on the electoral cycle have an incentive to boost short term economic growth at the expense of ever-higher inflation (exploiting the so-called Phillips curve). The problem is that, even if the government has no intention to do so, it does not have the means to credibly commit itself. As a result, rational and forward-looking agents will anticipate this inflationary policy bias anyway. This adversely affects current investment expenditure and hence potential growth in the longer term. The only workable solution to avoid this problem is to delegate monetary policy to a politically independent central bank.

Finally, the call for a Japan-style alignment of monetary and fiscal policy implicitly advocates the levying of an inflation tax to finance more expansionary fiscal policy. Such an inflation tax would, however, be itself undemocratic and hence be inconsistent with the criticism of undemocratic independent central banks.

Independence remains inherently fragile

On balance, economic theory and empirical evidence suggest that independent central banks are best suited to deliver medium-term monetary policy objectives within their legal mandate. The task of the elected government is to facilitate this, both by refraining from actively trying to intervene in monetary policy decisions, and by creating the appropriate institutional environment.

This is all the more important since central bank independence can never be taken for granted. Western central banks have not always been independent. For example, the Bank of England only gained the authority to set its policy rate as recently as 1997. Moreover, even at this moment the independence of central banks varies among jurisdictions. For example, a major difference between the ECB and the Fed is the non-renewability of the ECB’s Executive Board members’ mandate. This provides them a greater personal independence than the Fed Chair, who may take into account the probability of reappointment when setting policy.

An additional debate is whether banking supervision can or should be separated from monetary policy. It might be efficient to merge these tasks from a macroeconomic stability perspective, with appropriate ‘walls’ between them. If this joint policy mandate is implemented, however, there is a risk that monetary policy is no longer fully independent to raise interest rates, if this also significantly affects overall financial stability. Moreover, joining monetary policy and financial supervision may further feed the criticism that central banks have become too powerful, being institutions without an explicit democratic mandate.

Related to this, the overall fiscal and debt situation of the economy may also restrict the independence of monetary policy (the so-called fiscal dominance problem). For example, when reconsidering its highly accommodative monetary policy, the ECB is forced to take into account, at least implicitly, any impact this may have on overall debt sustainability in the euro area.

History has shown that central bank independence to achieve their legal mandate is not carved in stone. Although there may be many sensible arguments to challenge the status quo, the predominance of the electoral cycle over monetary stability is not one of them.

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