This informal CPD article on Central Bank Independence in Times of Crisis was provided by Shivani Sameer Pradhan, Research Intern at The Institute of International Monetary Research, an educational charity that promotes research into how developments in banking and finance affect the wider economy.
In the last three decades, most central banks have been given the mandate to achieve price stability over the medium and long term. Central banks (CBs) have been given autonomy to implement monetary policies in order to achieve this goal. The rationale is simple: an operationally independent central bank would be best equipped to promote de-politicised monetary policies and maintain low inflation, even if they carry political costs for governments.
In the absence of CB independence, monetary policy can be influenced by the government to serve their vested interests rather than the interests of the general public, which could thereby lead to poor and inconsistent policy decisions, focused on ad hoc political considerations. For instance, the incumbent governments would often be tempted to influence the central bank policy rate and inflate the budget deficit before the election period. This in turn will lead to too much money in the economy, an unsustainable rate of growth of the GDP and of the government deficit that eventually ends in a ‘boom and bust’ cycle.
Additionally, an independent CB will have relatively more expertise and credibility than a government with a record of high inflation. The trust in the institution in charge of controlling inflation is key to reducing inflationary expectations, which in turn translates into lower rates of inflation. Therefore, independent central banks offer a better arrangement than a politicised monetary policy at anchoring market expectations and indeed inflation.
During and after the Global Financial Crisis CB independence has been threatened. The focus of central banks broadened in terms of maintaining price stability along with financial stability and ‘supporting the economy’. Leading central banks resorted to unconventional monetary policies (i.e. Quantitative Easing) as a response to the crisis, which involved the purchase of a large stock of government bonds (as well as private bonds).
There is growing concern that the CB will face pressures from the governments to keep interest rates low even if inflations picks up in the future (a ‘fiscal dominance’ scenario). This is because governments are incurring increased fiscal deficits and would need to borrow more in the market to pay for the service of the debt with higher interest rates. In consequence, politicians are likely to pressure CBs into not raising interest rates even though it would be necessary to restrain inflation. Many advanced economies are struggling with a rising ‘debt pile’. For instance, in July 2020, UK national debt surged to 100.5% of GDP (£2,004bn) for the first time since 1961. This puts the Bank of England’s independence in jeopardy.
CBs are capable of tackling price and financial stability and their independence is desirable for the economy. However, as experienced in the last two major crises, their independence is at risk in times of a severe crisis. Therefore perhaps, the right question to ask is whether the central bank can truly be independent in the event of a great crisis and if we can find a better arrangement to maintain price stability and financial stability. Milton Friedman pointed out decades before the granting of central bank independence that the adoption of a well-defined (and binding) ‘monetary rule’ by the central bank can be even more effective in shielding the central bank from political pressures. Such a constitutional monetary policy rule would shield the price level from short-term political pressures and thus reduce the risk of a monetary policy under the control of the government.
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