Central Banking and Monetary Policy—A Brief Review

In considering the monetary policy role of central banks, it is useful to keep in mind the long history of central banking.² The original impetus to the development of the first central banks—in Europe—seems to have come from two main sources. First, governments began to realize that they could obtain financial assistance and advantages in return for supporting a particular bank in various ways. Such favoritism, often supported by legislation, could involve either a private bank (as with the Bank of England) or a specially established state bank (such as the Prussian State Bank).

Second, some early central banks (e.g., in Switzerland, Italy, and Germany) were founded specifically to unify the note issue system, manage and protect the metallic reserve of the country, and improve the payments system. Although broader economic benefits were seen in such moves—that is, economies of scale and increased confidence from the unification of the note issue system—there were also clear political attractions, especially, access to seigniorage revenue.

Through the first half of the nineteenth century, at least, these two areas largely defined the role of the then existing central banks. Even up to the early twentieth century, most economic analysis of central banking concentrated on the advantages or disadvantages of the note issue monopoly. What followed from these functions of early central banks seems to have been largely unrecognized by policymakers for some time.

Once central banking institutions existed with privileged legal positions as banker to the government and as currency issuer, these institutions began to develop into “bankers’ banks.” Their position as monopoly supplier of currency and as the government’s bank led to a concentration of the banking system’s cash reserves at the central bank. This, in turn, enabled individual banks to call on the central bank for temporary additional liquidity when required.

Moreover, since the existence of a central source of reserves enabled commercial banks to economize, on their own, individual cash holdings, there were marked tendencies for quasi-central banking mechanisms to develop in countries without central banks as such. In the United States, for example, clearinghouse associations and some large commercial banks used to provide these services for other banks. This suggests that government intervention to create a specific central bank, or to endow a pre-existing bank with monopoly currency issue and government banking privileges, may have served mainly to determine the particular form of central banking arrangement—which institution would be the central bank—rather than whether there would be such an arrangement at all.

In any event, their position as the ultimate source of domestic liquidity for the banking system meant that central banks became increasingly tied to two closely related areas of broader concern—a more micro concern for the health of the banking system, and a more macro concern for the state of monetary conditions in the economy in general. Because of perceived conflicts between these broader concerns and their competitive commercial banking operations, central banks eventually had to move out of their former competitive activities and concentrate on the “true” central banking functions. With the Bank of England and the Banque de France, for example, this took place in the second half of the nineteenth century.³ For similar reasons, most of the central banks established in the twentieth century were set up as entirely new and noncompetitive institutions (and where this was not the case initially, such as in Australia, a separate central bank was split out subsequently).

Compared with the long history of central banking, the development of a distinctive monetary policy function for central banks, built on top of their traditional functions, is relatively recent. Specifically, discretionary monetary policy developed into a defining feature of modern central banking following the abandonment of guaranteed convertibility of national currencies into gold at fixed exchange rates. In the absence of an external standard of value, the key determinant of the exchange value of money (i.e., the price level) became the rate of expansion of money itself. Governments thus became faced with the need to manage their currency, to some extent at least, on a discretionary basis.

The idea that central banks should have independence from political influence also has rather long historical roots and featured clearly in the discussions leading up to the establishment of many twentieth century central banks. In the past, the concern was that limits were needed on the government’s ability to fund itself through seigniorage. The more common contemporary interpretation of the problem is that the political leadership tends to take too short-term a view on the appropriate stance of monetary policy at any particular time: monetary policy consequently tends to take on a stop-and-go nature, reflecting excessive interest in fine-tuning. Monetary stability is, therefore, according to this view, more likely to be achieved over time when monetary policy is in the hands of apolitical central bankers who can afford to take the longer view.

Here, a distinction should be drawn between two different notions of monetary policy independence. First, monetary policy can be insulated from day-to-day political pressure by the relatively simple expedient of legislating some form of monetary policy “rule.” In the past, the gold standard was just such a rule. In recent times, there have been numerous proposals for new types of monetary policy rules to be established, and there is extensive literature on the long-running “rules-versus-discretion” debate. Under a rule, a central bank has monetary policy independence in only a limited sense—its freedom to devise and implement its own view of a desirable monetary policy may not be constrained by the political leadership, but it is heavily constrained by the rule.

Second, central banks can be endowed with monetary policy independence in a fuller sense when they are both insulated from political pressure and have considerable discretion in the determination and operation of monetary policy. This second notion of central banks’ monetary policy independence is clearly the more relevant concept in terms of current central banking practice, and it is monetary policy independence in this sense that is the subject of this paper.

Even in the situation where binding monetary policy rules do not apply, there may, however, still be important issues about the extent of a central bank’s discretion and how this relates to central bank independence. There is a wide middle ground between complete discretion and completely binding rules: commitments to monetary targeting and pegged but adjustable exchange rates, such as under the European Monetary System (EMS), are but two examples of a range of possibilities in this middle ground.

The problem for monetary policy today is to design an arrangement that makes the maximum contribution to achieving stability, built on monetary policy credibility, taking into account two inherent characteristics of the policy environment. First, no modern government appears willing to completely concede flexibility by committing itself to a binding monetary rule. Second, there will always be an element of difficulty in monitoring monetary policy performance, because the underlying monetary relationships are only imperfectly understood, do not work mechanically, can change over time (possibly quite sharply), and tend to involve long and variable lags between policy changes and final outcomes.

The Case for Monetary Policy Independence

The conceptual case for central bank independence in monetary policy is based on the view that policy credibility could improve the effectiveness and efficiency of monetary policy. Although the concept is not new, only in recent years has it been defined and analyzed in rigorous terms.⁴ A key feature of the new literature on credibility is the explicit modeling of the motives of policymakers and the constraints they face in a world where the public learns from experience and adjusts its expectations fairly rapidly. The value of this work is that it directs attention to the central importance of the actual and perceived objectives of monetary policymakers, and the mechanisms for establishing and protecting public trust in the operation of monetary policy.

Starting from the proposition that real output in the economy is invariant to anticipated inflation (and monetary growth) but increases temporarily with unanticipated inflation, it can be shown that when the policymaker has both inflation and employment and output goals, a “time inconsistency” problem arises for monetary policy. Specifically, although the policymaker may adopt an anti-inflationary monetary policy in one period, an incentive exists to reverse that policy at some stage in the future in order to engineer an inflation surprise and achieve short-term output gains. Furthermore, if the private sector recognizes the time inconsistency, and if the policymaker cannot make a credible precommitment to a lasting anti-inflationary policy stance, the monetary deflation (while it lasts) will make slower progress than otherwise and, in particular, will involve higher real sector costs. The reason is that inflation risk premiums will be incorporated into interest rates and price and wage decisions, and inflation expectations will decline only slowly. From a longer-term perspective, the economy would be seen to remain around the “natural rate” of output and employment with an inherent inflationary bias.

One potential solution is for a “reputational equilibrium” to be established over time. The policymaker builds a reputation for consistency and determination in monetary policy, possibly as much by actions taken in other economic policy areas as in monetary policy itself. The policymaker demonstrates willingness and ability to stay on the anti-inflationary course for a sufficiently long time, despite the costs, to establish credibility. This sort of solution, however, begs important questions. For example, if monetary policy credibility has to be earned by bearing additional real sector costs until the private sector changes its perception of the policymaker’s nature, what, if anything, can be done to hasten that process and reduce the costs? Additionally, since the private sector has to believe that the policymaker places a great weight on the cost of a damaged reputation, compared with the temporary gain from reneging on the anti-inflationary policy, how can the private sector be convinced that this is indeed the case?

Similar questions arise in considering possible solutions. Essentially, these other solutions seek to establish some form of institutional arrangement that would be seen by the public as a (more) credible precommitment to anti-inflationary monetary policy. Given that some measure of discretion in monetary policy is generally seen to be necessary, it might be possible to enhance credibility by ensuring that monetary policy is under the auspices of an independent authority that does not possess the same objectives and incentives as the political leadership. The key issues, then, become how to convince the public that such an authority is in fact independent, does in fact have the appropriate objectives, and is in fact motivated to achieve those objectives.

These are not straightforward issues. They force an explicit consideration of the actual behavior of central banks. As discussed further, below, studies that have examined actual central bank behavior indicate that it cannot be automatically assumed that central banks are motivated to consistently pursue appropriate monetary policy.

Some recent empirical work directly tests and lends limited support to the notion that countries with more independent central banks tend to deliver better inflation outcomes, and also that they have smaller and less variable fiscal deficits. While these results are suggestive and, to many, intuitively plausible, closer examination indicates that the evidence so far is less than compelling. There is also some indirect evidence drawn from studies of the end of past hyperinflations, but this may say more about the value of monetary policy “rules,” such as the gold standard, than central bank independence as such. Moreover, desirable arrangements for ending hyperinflations may not also apply to less extreme situations.

There are two main problems with empirical evidence produced so far: measurement and causation. First, with regards to measurement, formal legislative arrangements are not always a good indicator of actual independence; a number of less formal arrangements and practices may be more important. The political leadership often has a range of methods for exerting influence, irrespective of formal mechanisms. As a result, monetary policy outcomes are often seen to depend critically on the particular personalities involved at the time.

Second, with regard to causality, rather than central bank independence leading to lower inflation and better fiscal policy, it may be that both are due to a third factor. For example, it might be argued that the German public’s often quoted deep-seated fear of inflation has exerted a strong direct influence on the decisions of policymakers, as well as being behind the creation of an independent Deutsche Bundesbank.

Although the analytical case for central bank independence is now on rather firmer ground than previously, the view that such independence is necessarily desirable is far from universal. At one level, the notion of unelected central bankers determining a major element of economic policy is sometimes seen as contrary to democratic principles. At a different level, the value of independent central banks may be questioned on the grounds that they may not actually deliver superior monetary policy outcomes.

Although the “undemocratic” view is understandable, it is somewhat misdirected. It ignores the fact that no central bank is ever completely independent of government, if for no other reason than that the government, if political support is sufficient, can always change the legislation granting independence. On a more everyday level, governments can always exert influence over the policies implemented by central banks, over the longer run at least, through a variety of formal and informal mechanisms.

A more helpful way of analyzing the independence issue is to ask what, given the technical features of monetary policy, is a desirable degree of delegated responsibility for the central bank, and what are the desirable arrangements to establish it, recognizing that ultimate responsibility rests with the political leadership. To convey this sort of thought, some previous writers have referred to central bank independence within government, rather than independence from government.

A more substantial variant of the “undemocratic” criticism has to do with possible conflicts between an independent central bank’s monetary policy and other areas of economic policy, especially fiscal policy. When such a conflict arises, some would say, it is not appropriate for monetary policy to be unyielding. A related point in the analytical literature emphasizes that monetary policy credibility does not depend on monetary policy alone, but rather upon the government’s macroeconomic program in its entirety. In particular, when fiscal policy involves a stream of large deficits while an independent central bank pursues tight monetary policy, the economic program as a whole is not credible because eventually either fiscal or monetary policy has to give way. As Blackburn and Christensen (1989, p. 28) put it “[since] it matters considerably for inflation which of them does so,… [s]uch coordination problems generate uncertainty for private agents and invite speculation over how and when the conflict… will be resolved.”

A counter to this argument is that it may well be desirable for monetary policy to be independent, notwithstanding the potential costs of conflicts with other areas of policy, precisely because it makes transparent the costs of inappropriate policy in these other areas. For example, depending on the sensitivity of those responsible for fiscal policy to such visible costs, an independent monetary policy may have the advantage of providing a disciplinary check on other policies. As noted previously, there is some suggestive, but not conclusive, evidence in support of this view.

The other view of independent central banks not actually achieving superior monetary policy outcomes depends on the central objectives and motivations; they might conflict with the appropriate stance of monetary policy. The U.S. Federal Reserve, for example, is usually considered one of the most independent of central banks, but its revealed or actual independence may be less than commonly thought. A number of studies have argued that the Federal Reserve responds to political pressure because it values its formal independence, and, to protect that independence, it tries not to alienate the U.S. Congress or the administration. One study, for example, concluded that, in practice, “…[Federal Reserve] officials attempt to preserve its political power by such actions as following the monetary policies of the U.S. President.”⁵

If supposedly independent central banks in reality are motivated to follow the monetary policy of the political leadership in this way, independence may be even more harmful than a lack of it is purported to be. Formal independence that permits substantial backdoor political influence on monetary policy is likely to assist the political leadership in escaping its responsibility and accountability for monetary policy because of the nontransparency of the actual relationships involved. Monetary policy may still take on a stop-and-go nature in response to changing political winds, but the pretense of central bank independence could mean that the attention of the public and its elected representatives tends to be diverted from the medium-term performance of monetary policy so that it does not receive the analysis and review it deserves. In addition, this sort of situation may cause the central bank to employ nontransparent and suboptimal implementation procedures. It has been suggested that the tension between formal independence and actual, but unacknowledged, dependence may explain the Federal Reserve’s well-documented “noisy” operating procedures and its preoccupation with secrecy.

The foregoing discussion suggests that two main questions are to be considered in establishing or reviewing central bank independence arrangements. The first is what degree of formal independence (“delegated authority”) is likely to be considered desirable and realistic by politicians and society in general in the country in question? The second is, given the intended degree of central bank independence, what are the detailed arrangements that will be needed to put that independence in place, including especially the appropriate accountability arrangements? Even if the credibility argument for central bank independence is accepted in principle, the desired degree of independence is likely to depend on a number of country-specific factors. We could speculate that such factors might include a country’s inflation history, the nature of existing checks and balances in the political system,⁶ the level of public awareness and debate of economic issues, the state of development of financial markets, and so on. The next section examines the practice with respect to these questions.

Dimensions of Monetary Policy Independence

The discussion above suggests that the detail of the arrangements governing the relationship between central banks and governments may be particularly important if the potential credibility benefits of central bank independence are to be captured. The following sections discuss key aspects of these arrangements.

Statutory Objectives

In general—and at the risk of oversimplification—central banks that have little policy independence tend to have statutory objectives that are more broadly defined—for example, the Bank of England’s legislation refers only to promoting the “public good”—or defined in terms of functions, rather than goals. Banks with greater formal independence tend to have a statutory objective with a somewhat narrower focus, emphasizing stability in the domestic or external value of the currency (Germany, Netherlands, New Zealand, and Chile). The central banks of Switzerland and the United States could be viewed as exceptions to this generalization. Although Swiss legislation does not narrowly define an objective for the Swiss National Bank, the Bank has apparently done so on its own behalf. At first sight, the purpose stated in the Federal Reserve’s legislation appears to approximate a fairly classical expression of a longer-term price stability objective, but the legislation is open to other interpretations in terms of day-to-day implementation.

Based on conceptual analysis, one would expect more independent central banks to have more narrowly defined statutory objectives, for several reasons. First, since monetary policy influence is essentially a single policy instrument, it cannot be simultaneously assigned to more than one policy target, especially when conflicts between those targets are possible in the short term.

Second, it is now widely accepted that active monetary policy manipulation cannot achieve sustainable, worthwhile aggregate real sector effects, but that, on the other hand, a firm and stable monetary policy is necessary for longer-term price stability. In short, therefore, monetary policy has a comparative advantage in achieving price stability relative to “real” economic objectives.

Third, central bank independence in monetary policy does not make sense if the central bank has multiple macroeconomic objectives, such as growth and employment, balance of payments, or distribution, as well as stabilizing the value of the currency. In this case, effective coordination and accountability would appear to require that the central bank be firmly under government control, since different organs of government would then be pursuing different mixes of essentially the same group of objectives.

Fourth, multiple objectives would reduce the transparency of monetary policy, and, for this reason too, would weaken the accountability of both the central bank and the political leadership. With multiple objectives, policy failure with respect to one objective can be too easily excused by reference to other objectives. Similarly, if the objectives are not clearly defined, those responsible for monetary policy cannot be effectively accountable.

Finally, and perhaps most important, it is the public perception of risks of policy reversals, and of changing policy targets, that weakens the credibility of monetary policy. Multiple or unclear objectives, therefore, do not seem likely to be consistent with the desire for monetary policy credibility. It is this credibility, however, that ultimately is the basis of the argument for central bank independence.

These arguments point to the desirability of a single, clearly defined price stability objective for an independent central bank’s monetary policy. A bank’s statutory objective does not have to be so specified, as long as a mechanism for clearly establishing the objective to which monetary policy will be aimed is available (compare Switzerland). Nevertheless, a single, clear, statutory objective is likely to be helpful.

Monetary Policy Accountability

Defining clearly the objective of monetary policy goes only part way toward promoting increased monetary policy credibility. The public also has to have some degree of certainty that an independent central bank is in fact being motivated to achieve that objective. This requires that the public is able to adequately monitor the performance of monetary policy and, directly or indirectly, hold accountable those responsible for its formulation and implementation. It seems clear that transparency in the relationship between the central bank and the political leadership is a precondition for effective accountability.

In general, and with the notable exception of New Zealand, the legislation of the surveyed central banks does not establish strong accountability mechanisms. In New Zealand, accountability focuses more on an individual, the governor, than on the central bank as a whole and is based on published policy targets, agreed upon between the governor and the minister, to be achieved during the governor’s term of office. Formal monitoring of performance, relative to the policy targets and the Bank’s statutory objective, is through the Bank’s annual report to the minister (tabled in Parliament) and, more especially, through six-monthly “policy statements” to the minister (also tabled in Parliament), and through the Bank’s board.

For the Bank of England and the Banque de France, with no formal independence, a lack of strong accountability mechanisms for the banks themselves in relation to the direction of monetary policy is perhaps not surprising. There is no doubt that the relevant minister, and the government as a whole, bears responsibility for formulation and implementation of monetary policy, and parliamentary review proceeds accordingly. In the United Kingdom, a parliamentary committee examines the governor or other officers of the Bank regularly with particular attention to the implementation, rather than the direction, of monetary policy. Parliamentary examination is less frequent in France. The banks’ annual reports are the main formal instruments of accountability, presented to the president, in the case of France, and to Parliament through the minister, in the case of the United Kingdom. Parliamentary review of monetary policy in the Netherlands is less direct, with the Nederlandsche Bank reporting to the Bank Council, which is chaired by the Royal Commissioner, appointed by the Crown to supervise the Bank’s affairs and formally accountable to the Crown.

In the United States and Chile, the legislature has an important direct role. The Federal Reserve is required to report to Congress semiannually. While the legislation still requires the Federal Reserve to discuss monetary aggregate targets, it is not bound by its statements about its targets. In addition, the Chairman and other members of the board frequently testify before various congressional committees. In Chile, the central bank reports annually to the president and the senate; the reports include the policies and programs to be adopted in the following year.

The central banks in Germany and Switzerland are not formally accountable to any arm of government, but have instead put considerable weight on the publication and attainment of monetary aggregate targets since the mid-1970s, thereby facilitating monitoring of monetary policy performance directly by the public. The Bundesbank is required to publish an annual report, but it is not presented to the government or parliament. The Swiss National Bank reports annually to its shareholders (which do not include the federal government).

Quantity targets for monetary policy are also set and published in other countries in this survey. In France and the United Kingdom, targets are set and announced by the government and, in terms of establishing monetary policy credibility, may partially compensate for the lack of an independent central bank. In the Netherlands, Germany, and Switzerland, it is the central bank that sets the targets, but in the Netherlands targets are not published because of the need to also maintain exchange rate stability within the EMS. Although the new law in Chile does not state operating procedures for monetary policy, in practice the central bank sets the targets. In New Zealand, it is a legislative requirement that monetary policy targets be set. Although the legislation does not specify the nature of the targets to be set, it requires that all key documents relating to central bank accountability (including in particular those setting out the policy targets) be published and tabled in Parliament.

In the United States, the Federal Reserve used to stress its quantity targets, but since the early 1980s has been de-emphasizing these targets citing instability in behavioral relationships due to technological, regulatory, and institutional factors. The Federal Reserve is, however, required to publish the minutes of its main decision-making body, the Federal Open Market Committee (FOMC), but with a six-week delay.

Role and Composition of Central Bank Boards

The role and composition of central bank boards can have an important influence on the nature of the relationship between central banks and governments. In some cases, the boards are a formal channel for the government to exert influence directly, albeit temporarily, on central bank decisions.

The board structure may have up to two or three tiers. Switzerland and the Netherlands both have a three-tier structure. The Swiss structure consists of a three-man Directorate conducting day-to-day policy and administrative business; a 40-member Bank Council, which is the general supervisory body responsible to shareholders and meets at least quarterly; and the Bank Committee, a subcommittee of the council with up to ten members, carrying out a more detailed supervisory function and meeting monthly. The committee also advises the directorate. In the Dutch structure, an executive Governing Board is responsible for ongoing management of the bank and reports to a 12-member Supervisory Board. There is a 17-member Bank Council, which advises the minister on the guidelines that the bank should follow in its policy. The Council is chaired by the Royal Commissioner, whose role is to supervise the affairs of the bank. The commissioner also attends meetings of the governing and supervisory boards in an advisory capacity.

In the United States, Germany, and Chile, there are two-tier structures; one level is supervisory, and the other is a regular decision-making (executive) body. In the United States, the decision-making body (the FOMC) is larger than the governing body (the Board of Governors) and includes all the members of the latter. In France, New Zealand, and the United Kingdom, there are executive committees for day-to-day management, but these are not formally established by legislation, which only covers the supervisory board. In New Zealand, the responsibilities of directors are clearly defined to emphasize their duty to monitor, on behalf of the minister, the performance of the governor, and the Bank as a whole, in relation to the agreed policy targets and the Bank’s statutory objective.

In all cases, the government appoints the majority, if not all, of the members of these bodies (see below), but there may also be ex officio or advisory board members representing the government or treasury explicitly. In Germany and France, the government representative can request that a board decision be temporarily deferred or (in France only) reconsidered. In Chile, the minister or his deputy may attend council meetings and request a temporary deferment, unless at least four council members insist otherwise. In other countries (the United Kingdom and New Zealand), explicit government representation is directly ruled out.

The spread of sectoral and regional representation is often seen as an important criterion for the composition of the board (France, United Kingdom, Switzerland, United States, and the Netherlands), but in other cases, general business or financial knowledge and experience (New Zealand), or even “special professional qualifications” (Germany) are specified.

Appointment and Dismissal of Management and Directors

The fact that governments have the primary role in the appointment of directors and management in all countries reflects a broad recognition that monetary policy is ultimately a government responsibility, even where the central bank has considerable statutory independence. Nevertheless, in banks that have a greater degree of independence, the government’s appointment (and dismissal) powers generally have more limitations. Such limitations include a proportion of nongovernment appointments;⁸ nongovernmental nomination of candidates; or terms of office that are relatively long compared with the electoral cycle, and, in the case of board members, staggered to reduce the ability of governments to quickly place their own appointees in a dominating position.

For the two least independent central banks in the survey, the head of state makes all the appointments, either on the recommendation of (United Kingdom) or in consultation with (France) the cabinet, and without formal reference to other parties. The only exception is that one Banque de France director is elected by the staff. In the United Kingdom, the governor and deputy governor have five-year terms, and directors have staggered four-year terms. In France, directors have staggered six-year terms, and the governor and deputies are appointed for indefinite terms, which are, in practice, limited to five to seven years (the seven-year term is of equal length to but not necessarily concurrent with the French president’s term).

In other countries, bank boards have an important role in appointment procedures. In New Zealand, the government appoints directors for staggered five-year terms, and appoints the governor on the recommendation of the board, also for a five-year term. The deputy governor is appointed by the board, on the recommendation of the governor, again for a five-year term. In the Netherlands, individual members of the Governing and Supervisory Board are appointed by the government, on the joint recommendation of the current members of these boards, for staggered terms of seven years for governing board members and four years for supervisory board members. Four of the seventeen bank council members are appointed by the Supervisory Board for the remainder of their terms as directors, and twelve others are appointed by the government for staggered four-year terms. The final member of the council, its chairman, is the Royal Commissioner, also appointed and dismissed by the government.

In Chile and the United States, board members are appointed by each country’s president, subject to senate approval, for terms of 10 and 14 years, respectively. The bank president in Chile and the U.S. Federal Reserve chairman and vice chairman are appointed by the country’s president, subject to senate approval, from the ranks of the respective boards for five- and four-year terms, respectively.⁹ In the United States, the presidents of the regional reserve banks who, together with the board, make up the FOMC, are appointed by the regional bank boards. The regional bank boards themselves are made up of equal numbers of directors representing member commercial banks, directors who are nonbankers but who are elected by member banks, and directors appointed by the Federal Reserve Board. The regional bank presidents have to be drawn from this latter group.

In Switzerland, the members of the Directorate (the governor and two deputies) are appointed by the Senate, on the recommendation of the Bank Council, for six-year terms. The governor and one deputy become president and vice president of the Bank Council and Bank Committee. Other bank committee members have four-year terms, and are appointed by the council from among its own ranks. Of the 40 council members, 15 are elected by the shareholders. (As already noted, the federal government is not a shareholder.)

In Germany, the Bundesbank president, the other members of the Directorate (the executive body), and the Länder bank presidents are almost invariably appointed for the maximum eight-year term. The president and the other directorate members (up to eight) are appointed by the German president, on the nomination of the federal government, after consultation with the Bank Council, the supervisory body comprised of the Directorate and the eleven Länder bank presidents. The Länder bank presidents are appointed by the federal president, on the nomination of the federal parliament, in turn based on recommendations from provincial governments and after consultations with the Bank Council.

Directors or governors can generally be removed for relatively technical causes, such as bankruptcy, criminal offenses, major conflicts of interest, and so on. There does not seem to be a clear pattern with respect to dismissal on other grounds. In Germany and the United Kingdom, the legislation contains no other grounds for dismissal. In France, there is no limit on the president’s ability to remove incumbents, and in the United States, the president may remove board members “for cause.” In Chile and the Netherlands, the government may remove incumbents on the recommendation of the board (at least three council members, in Chile) or for a justified cause. In New Zealand, the government can remove directors for unsatisfactory performance (relative to the defined role of the board), and can remove the governor or deputy for unsatisfactory performance in relation to achieving agreed policy targets in particular, whether or not recommended by the board.

Central Bank Budgetary Independence

Except in France and New Zealand, the central banks covered in this survey have substantial financial independence from government across all of their functions, irrespective of the degree of monetary policy independence. This is due mainly to their ability to determine their own current expenditures, and the knowledge that in most cases, their revenue is unlikely to present a constraint on their spending. Even when a bank is required to provide concessional finance of some sort, this is still likely to be the case in the countries surveyed.

Central bank income usually arises from seigniorage revenue in the form of interest earnings on assets backing the note issue. Often, assets backing nonremunerated reserve deposits at the central bank also provide such revenue. In the United Kingdom, for example, it is widely acknowledged that the 0.5 percent cash-reserve requirement imposed on banks is a funding mechanism for the Bank of England and has no real monetary policy significance.

Central bank profits, after allocations to reserve funds and any dividend payments, are invariably transferred back to the treasury. This appears entirely appropriate, given that it is governments that have granted central banks monopoly note issue privileges and the ability to impose effectively binding reserve requirements. There are usually arrangements specified in the legislation for the distribution of central bank profits, though in some cases (e.g., the United Kingdom and France), the distribution is specified by, or negotiated with the government. An exception is the United States, where the Federal Reserve banks themselves decide what amounts should be set aside in reserve funds.

There are several issues to be considered in relation to budgetary independence. First, to what extent is such independence required to support policy independence? A potential concern for a bank with policy independence is that a government could indirectly exert undue influence on the bank’s policy by restricting its access to resources. On the other hand, when a central bank is clearly carrying out the government’s monetary policy, there appears to be no compelling policy argument for financial independence.

A second question relates to the form of funding for the central bank. How much does it matter if an independent central bank’s revenue appears to provide a financial incentive structure inconsistent with the presumed goal of monetary stability, that is, if a central bank’s revenue in real terms rises with inflation. It has often been noted that seigniorage revenue has this feature, as does the similar revenue from reserve requirements. The reason is that if inflation is accelerating, such revenue increases faster than the general price level: not only does revenue increase as the note issue and required reserves grow more or less in line with inflation, but it increases even further if nominal interest rates also rise in line with higher inflation. In such a situation central bank revenue would be doubly compensated for inflation. The concern here has more to do with how the inconsistent incentive structure might be publicly perceived, rather than about whether independent central bankers would consciously soften monetary policy as a result of revenue considerations.

A third issue is how to ensure that the central bank, if it has budgetary independence, nevertheless achieves the same sort of financial efficiency that is expected of any other public policy organization. The response in most countries has been to rely on the banks’ boards to ensure financial efficiency. There is always a risk, however, of a board being “captured” by the organization it monitors if the incentive and accountability structure is not well designed. In practice, and justifiably or not, it is sometimes a point of some sensitivity that central banks frequently offer considerably better facilities, salaries, and benefits than the civil service.

In an attempt to seek an appropriate balance between considerations such as the above, the new central bank legislation in New Zealand takes a course on budgetary independence quite different from arrangements in the other central banks surveyed. Reflecting the desire to ensure financial efficiency and remove inconsistent financial incentives, all public policy functions of the Reserve Bank will be funded under an agreement between the minister and the governor, ratified by Parliament.¹⁰ Reflecting the need to support policy independence, however, this agreement covers Reserve Bank expenditure over a five-year period, rather than requiring approval of expenditure budgets on a year-by-year basis.

Constraints on the Use of Monetary Policy Instruments

In some contexts, monetary policy independence could be seriously impaired if the central bank did not have the freedom to manipulate the instruments of monetary policy as it sees fit, and without the need for approval by the government. This does not appear to be a problem for the most independent central banks in this survey, but could affect some of the other countries surveyed. In addition, in some developing countries, monetary policy independence has been reduced, owing to a lack of well-developed financial markets and money market instruments and the consequent need to rely on coordination with government debt management. For example, the use of treasury bill auctions for monetary policy purposes requires close coordination with fiscal authorities; this could often constrain the freedom of action by the central bank.

There are often limits on the ability of central banks to vary reserve requirements, but since the general trend is away from actively using these in monetary policy, this is unlikely to be a constraint for the countries involved. The most obvious example here is New Zealand, where reserve requirements were removed in 1985; new legislation would be required to reintroduce them. The view was that the normal legislative procedures should be followed if it was thought necessary to return to an instrument involving compulsion. In the United Kingdom and the Netherlands, the central banks would be able to vary reserve requirements, if they wished to, by making “recommendations” to bankers: but if agreement could not be reached with the bankers, government approval would be required before legally binding directives could be issued. In France, a change in reserve requirements needs to be approved by government, through the National Credit Council. In Germany, the United States, and Chile, the central banks are able to vary reserve requirements: the Federal Reserve has not actively varied requirements in the past, but the Bundesbank has.

Associated Functions of Central Banks

The major functions undertaken by central banks at different times and in different countries vary in a number of respects. These functions can be broadly divided into those directly involved in monetary policy operations and those of other associated functions:

Functions most closely related to the conduct of monetary policy include

• bankers’ bank;

• management of the currency issue; and

• government’s bank.

Other functions include

• supervision of financial institutions and markets;

• lender of last resort;

• carrying out exchange rate policy, including foreign exchange market management and control;

• holding and managing international reserves;

• fiscal agent and management of public debt;

• quasi-fiscal functions, such as subsidization of specific sectors, equity participation in financial institutions, etc.;

• deposit insurance; and

• participation in clearing and settlements.

In the first group of functions, the bankers’ bank role and currency issue are fundamental to central banking and are at the very core of monetary policy.¹¹ In many countries, the role of government banker has also been close to the core of monetary policy, although it seems clear that this is not an essential central bank function.

The functions in the second group are not so closely related to monetary policy; however, they are associated with central banks to some extent at least. The purpose of this section is to examine the extent to which these associated functions are, or should be, undertaken by central banks, and, if undertaken, the extent to which they constrain or complement monetary policy independence.

Conclusion

Several countries have either recently made or are in the process of considering significant changes to their central banking legislation, generally aimed at making their banks more independent in the formulation and operation of monetary policy. In light of these developments, this paper has reviewed the main issues relating to central bank autonomy, and the potential links between such autonomy and the choice of central bank functions. A limited initial survey of eight countries, including two where new legislation has just been introduced or is about to be enacted, was used as a reference base.

Although the theoretical grounds for central bank independence are now on a rather firmer footing than previously, it is not possible to draw strong conclusions about the desirability of central bank independence in practice. So far, the evidence is not more than suggestive. Nor is it easy to make conclusive inferences about the detailed design of relationships between the central bank and government from a very limited survey such as this. So much depends on the practice of often informal institutional and political arrangements, and both these and formal legislated arrangements vary widely from country to country.

Notwithstanding these reservations, central bank independence does appear to have the potential to improve longer-run inflation performance, or to buttress other arrangements, which provide a disciplinary check on monetary policy. The major point to emphasize, however, is that the detail of the institutional framework is likely to be an important determinant of the contribution that formal central bank independence makes in practice, and indeed to the sustainability of such formal independence. In particular, the legislated framework may need to structure as much as possible these less formal aspects of government-central bank relationships. This is likely to be of particular importance for a country attempting to build monetary policy credibility against an historical background of variable and generally insufficient monetary restraint. In this regard, it will be very interesting to review in the future the experiences of Chile and New Zealand, with their different approaches to central bank independence.

The following additional points seem to be of particular importance in designing central bank independence arrangements. First, for both practical reasons and reasons of constitutional principle, it is not helpful to think of the ultimate responsibility for monetary policy lying anywhere else than with the political leadership. Governments may, however, choose to impose constraints on the extent of their own monetary policy freedom, and that of future governments, by delegating certain authority to central banks. The extent to which they choose to do so is likely to depend on a number of country-specific factors, including past inflation and monetary policy experience, the nature of existing checks and balances in the political system, the economic awareness of the public, and so on.

Second, seen from the perspective of delegated authority, it is clear that central bank autonomy needs to be accompanied by effective monetary policy accountability. Depending on the extent of delegation, such accountability might be to the executive arm of government, to the legislative arm, or direct to the public.

Third, clear, nonconflicting objectives and a structure of incentives and sanctions that align the motivations of the central bank, as monetary policy agent, with what is considered to be welfare-maximizing monetary policy, are important requirements. Without these, the effective execution of the delegated authority and effective accountability may suffer. These considerations are as much a matter of sound management principles as technical considerations from monetary economics.

Fourth, for similar reasons, the respective roles of the central bank and the political authorities need to be clearly set out, and the relationships between the two need to be transparent and consistent. There is unlikely to be any gain in monetary policy credibility from a more autonomous central bank if there are suspicions of backdoor influence.

Fifth, if there are conflicts and trade-offs inherent in a central bank’s functions, monetary policy independence and credibility might, in the extreme, require reconsideration of the mix of functions allocated to the central bank. Short of that, there need to be transparent mechanisms for the resolution of such conflicts, with decisions preferably made outside the central bank so that the central bank is not seen to be shifting monetary policy objectives. Even if the inherent conflicts with monetary policy are not substantial, there may sometimes be scope for extreme political sensitivity in relation to some of the nonmonetary policy functions of the central bank, which could impinge indirectly on the monetary policy function. In this case too, the allocation of responsibilities might need to be examined.

Finally, it is worth noting that central bank independence by itself cannot guarantee monetary policy credibility. This depends very importantly on the credibility of economic stabilization and adjustment policy as a whole. For example, where exchange rate policy or fiscal policy is widely seen as inappropriate, the best that can be hoped for is that an independent central bank may help to make the costs of those inappropriate policies more visible.