Can it contribute to better inflation performance? Issues in theory and practice
There has been considerable interest recently in increasing the independence of central banks in the formulation of monetary policy. Chile and New Zealand enacted new legislation to this effect in 1989, and several other countries in Latin America and Eastern Europe are studying specific proposals with a similar purpose. There has also been some public discussion of increased central bank autonomy in several major industrial countries. In particular, the moves toward European monetary union have brought forth proposals for an independent supranational central banking system requiring, in the view of some members of the European Monetary System (EMS), a prior move to independent national central banks.
These developments naturally raise important questions about the desirable relationship between central banks and governments (see also “The Role of Central Banks” by Richard Erb, Finance & Development, December 1989). The last few years have seen a growing volume of literature suggesting on conceptual, and to a lesser extent empirical, grounds that independent central banks may promote price stability. This view, however, is far from universal. Moreover, little attention has been given to the issues involved in establishing such independence in practice.
This article is based on a more detailed study entitled “Central Bank Independence: Issues and Experience”, IMF Working Paper WP/91/58, available from the authors.
This article discusses these issues on the basis of a more detailed examination of arrangements in Chile, France, Germany, Japan, New Zealand, the Netherlands, Switzerland, the United Kingdom, and the United States.
The case for independence
The argument for central bank independence is that the “credibility” of monetary policy, and hence its ability to achieve and maintain longer-run price stability with minimum real economic costs, would be improved if policy formulation were in the hands of apolitical officials who can afford to take a long-term view. The conceptual basis for this view has been formalized relatively recently in terms of the “time inconsistency” problem in monetary policy. It can be easily shown that if elected policymakers have both inflation and employment or output objectives, they may have an incentive to seek short-run output gains by reneging on previously announced noninflationary monetary policy. Similar problems arise if the policymaker’s motive for relaxing monetary policy relates to income distribution or revenue issues. Assuming that the public recognizes the incentive to renege, if the policymaker cannot make a credibly binding precommitment to noninflationary policy stance, nominal interest rates will be higher, with inflationary expectations declining relatively slowly (if at all), compared to the case where the public believes the policymaker has only a price stability objective.
Possible solutions to the time inconsistency problem relate to the measures essential to convince the public that the policymaker will remain committed to a stable, noninflationary monetary policy. One option advocated by some economists is to legislate some form of fixed rule for monetary policy. Historically, the gold standard provided a form of fixed monetary rule. Other economists argue that a fixed rule would be undesirable because flexibility (“discretion”) is required to allow monetary policy to react to unanticipated disturbances like supply shocks or shifts in the demand for money.
However, there is a wide middle ground between fully binding monetary rules and full monetary policy discretion, and monetary policymakers have often chosen to establish arrangements which limit, to some extent, their own scope for discretion. Examples of arrangements in this middle ground include the announcement of monetary targets or fixing the exchange rate to a low inflation currency as an external constraint. But since such arrangements are not fully binding, they do not fully resolve the credibility problem. Under a fixed exchange rate regime, for example, the credibility of the particular peg chosen becomes central, and thus the same policy issues that arise in a flexible exchange rate system—in particular, the stance of demand management policies—assume significance.
Arrangements such as the above can, however, be seen as attempts to allow for some monetary policy discretion, while improving the credibility of monetary policy by making it more “transparent,” that is, by making it clearer to the public what specifically monetary policy is attempting to achieve. More transparent monetary policy is potentially valuable because, in general, monetary policy performance can be difficult to monitor and assess. The underlying monetary relationships are only imperfectly understood, do not work mechanistically, can change over time (possibly quite sharply), and tend to involve long and variable lags between policy changes and final outcomes. Thus, it can be difficult to independently distinguish the extent to which actual developments reflect shifts in policymakers’ ultimate objectives, or other factors.
It is against this background that many economists see merit in having an independent monetary authority, which would, in some sense, be more trustworthy in the exercise of monetary policy discretion! But this view is far from universal. The notion of unelected central bankers determining a major element of economic policy is sometimes seen as contrary to democratic principles. This view seems to ignore the fact that no central bank is ever completely independent of government: There are invariably a number of formal or informal channels through which governments can influence monetary policy and, in extreme cases, governments can always change central bank statutes. Another objection sometimes raised is the potential costs of conflicts between an independent monetary policy and other areas of policy, especially fiscal or exchange rate policies. However, it may well be desirable for monetary policy to be independent precisely because it brings out more clearly the costs of inappropriate policies in these other areas.
Perhaps a more fundamental concern about the value of independent central banks is that they may not actually deliver better long-run inflation performance. Insofar as central banks have their own internal objectives and motivations, they may conflict with maintaining a noninflationary monetary policy stance. For example, a number of studies have suggested that a central bank’s behavior is likely to be colored by a wish to avoid conflict with the groups that have the power to influence its status and by a desire to maintain its autonomy and the scope for exercising its discretion. This body of work is a salutary reminder of political realities, suggesting that in the absence of other safeguards, there may indeed be a risk that central banks’ behavior could give rise to problems of monetary policy credibility and inflation bias very similar to those that are assumed for an elected policymaker.
Although some empirical studies support the view that central bank independence promotes improved inflation performance, the evidence is not conclusive. Furthermore, there are some important “anomalous” cases where inflation performance has been superior, despite the absence of a central bank with substantial statutory independence. Japan and France are important examples. Monetary policy in Japan appears to have been more politically independent in practice than the Bank of Japan’s legislation might suggest, while in the case of France, the EMS arrangements are no doubt an important external source of discipline and a partial signal of commitment to financial restraint. In countries with highly independent central banks, a basic issue yet to be adequately resolved is the extent to which ingrained social preferences for low inflation are the real cause of stronger financial discipline and better inflation performances; if such is the case, one wonders whether central bank independence makes an additional contribution to price stability.
It must also be recognized that formal legislative arrangements, usually forming the basis of independence measures in empirical studies, are not always a good indicator of actual independence. As noted above, the political leadership often has a range of methods—as well as the incentive—for exerting influence, irrespective of formal mechanisms. As a result, perhaps, monetary policy outcomes may be seen to depend critically on the particular personalities involved at a given time.
Issues involved in practice
A country considering the merits of creating an independent central bank would need to address two main questions. First, what degree of formal independence is likely to be considered desirable and realistic by politicians—and society in general—in the country in question? Even if the argument that central bank independence could improve the credibility of monetary policy is accepted in principle, the desired degree of independence is likely to depend on a number of country-specific factors. Such factors might include a country’s inflation history, the nature of existing checks and balances in the political system, the level of public economic awareness and debate, and the state of development of financial markets.
Second, given the intended degree of central bank independence, what are the arrangements required to implement this degree of independence in such a way that the course of monetary policy would not depend on the individuals involved at particular times? The details of such arrangements are likely to be very important and would need to take into account the incentives under which politicians and central bankers tend to operate, and the nature of formal and informal relationships between them. The range of actual practices in these areas is summarized below.
Formal monetary policy responsibility and conflict resolution. The central bank’s duty to conduct policy, at least in consultation with the political authorities, is widely acknowledged, but even in this context, varying degrees of independence for the central bank prevail. Germany’s Bundesbank and the Swiss National Bank (SNB) are commonly considered as the most independent central banks: The Bundesbank is not required to take government policy into account if it is inconsistent with its statutory role of preserving stability in the external and internal value of the currency, while the SNB is required to consult the Swiss Federal Government (and vice versa) but is not required to obtain its approval. At the other extreme, central banks such as the Bank of England and the Bank of France, are advisors and implementors of monetary policy, while the responsibility for important monetary policy decisions clearly rests with the government. Of the central banks between these extremes, some may be rather more or less independent in practice than their formal statutory positions suggest (e.g., the Bank of Japan and the US Federal Reserve, respectively).
Some other central banks (e.g., in the Netherlands and New Zealand) follow a third type of arrangement, whereby the central bank has substantial monetary policy autonomy but can potentially be overruled by the government. The important point about these arrangements, however, is that any overruling of the central bank has to be done publicly. This compromise of sorts is intended to provide an effective disciplinary check on the government and a safeguard for the central bank in its relationships with the government, while still recognizing explicitly that the ultimate responsibility for monetary policy lies with the government.
Statutory objectives. In general, central banks with greater formal independence tend to have a statutory macroeconomic objective with a relatively narrow focus, which emphasizes stability in the domestic, and perhaps also the external, value of the currency. This general tendency, seen for example in Chile and New Zealand after 1989, and in Germany and the Netherlands, is explicable in terms of the desire to promote monetary policy credibility. Since the propensity of policymakers to shift between different objectives is the basis of the credibility problem, multiple or unclear statutory objectives are not likely to be consistent with this desire. Instead, they would tend to reduce the transparency of monetary policy and thus weaken the accountability of both the central bank and the political leadership)—policy failure with respect to one objective could be too easily excused by reference to other objectives.
These points suggest the value of a single, clearly defined statutory objective of price stability for an independent central bank’s monetary policy. For a country desiring to make a break with past monetary policy and promote greater monetary policy credibility for the future, as opposed to one where the central bank already has a well-established reputation for monetary restraint, the maximum degree of clarity in its statutory mandate is likely to be particularly important.
Monetary policy accountability and monitoring. Defining clearly the objective of monetary policy is not, by itself, sufficient for increased monetary policy credibility. It is also essential to assure the public that an independent central bank is in fact being motivated to achieve that objective. Inter alia, this requires that the public be able to monitor adequately the performance of monetary policy and hold accountable—directly or indirectly—those responsible for its formulation and implementation.
In general, and with the notable exception of New Zealand, the legislation of most central banks does not establish particularly strong accountability and monitoring mechanisms. Most of the more independent central banks nevertheless seek to provide relatively easily observable measures of performance to facilitate public monitoring of monetary policy and allow the general objective of the central bank to translate into concrete guidelines for policy. In the case of the Bundesbank and the SNB, this has been in the form of commitments to monetary aggregate targets. Membership of the EMS exchange rate mechanism in the Netherlands serves the same function. In New Zealand, an explicit target path for inflation has been established (involving a range of between 0-2 percent inflation by the end of 1993), and this is tied to what is essentially a performance contract for the Governor of the Reserve Bank. Canada has also established such an inflation target path recently, though without the same legislative backing as in New Zealand, and similar proposals have been considered for the United States.
Role, composition, and appointment 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 represent a formal channel for the government to exert some influence directly on central bank decisions. Governments effectively appoint the majority, if not all, of the members of central bank boards, and there may also be ex officio or advisory board members representing the government or treasury explicitly. However, in banks that have a greater degree of independence, there are generally some limitations on the government’s appointment (and dismissal) powers. Such limitations include provisions for nongovernment appointments, nongovernment involvement in the appointment procedures, or relatively long and staggered terms for directors to reduce the scope for governments to load central bank boards with their own appointees.
Limits on financing of government. A potentially important aspect of monetary policy independence may be the extent of legal constraints on central bank funding of the government. Chile has unusually tight restrictions, prohibiting any direct or indirect central bank financing of public expenditure (except under wartime conditions), and any central bank purchases of paper issued by the government, its agencies, or enterprises. In other countries, such as Germany, Switzerland, and the Netherlands, the legislation sets strict limits on direct central bank credit to Government, but allows government paper to be acquired in the course of open market operations.
Though they may be important in presentation, the technical effectiveness of statutory limits on credit to government is somewhat dubious. In practice, they may not be particularly effective when the central bank is not independent and may not be necessary when the central bank is independent, with a clear responsibility for monetary stability. However, statutory limits could still prove useful in promoting monetary restraint in the case of a nonindependent central bank in a country with relatively less well-developed financial markets—if these limits are actually respected.
Central bank budgetary independence. Irrespective of the degree of monetary policy independence, central banks commonly have substantial financial independence from their governments and, in particular, can usually set their own expenditure budgets. Exceptions include France, Japan, and New Zealand. A potential concern for a bank with policy independence is that, in the absence of accompanying budgetary independence, a government could indirectly exert undue influence on the bank’s policy by restricting its access to resources. In New Zealand, this concern is reduced because the funding agreements negotiated with the government cover five years, rather than requiring an annual budgetary approval. On the other hand, where a central bank is clearly carrying out the government’s monetary policy, there appears to be no compelling policy argument for financial independence.
Although the empirical evidence so far is less than compelling, on conceptual grounds it can be argued that central bank independence does have the potential to improve longer-run inflation performance. 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 can make in practice to price stability, and indeed, even to the sustainability of such formal independence. In particular, a great deal may depend on the nature of informal institutional and political arrangements and the incentives under which central bankers and politicians operate. Therefore, the framework as legislated may need to pay close attention to the structuring of these less formal aspects of government-central bank relationships, through, inter alia, appropriate arrangements for settling monetary policy objectives or targets, and for maximizing the degree of monetary policy transparency. This is likely to be of particular importance for a country attempting to build policy credibility against a historical background of variable and generally insufficient monetary restraint.
Marta Castello-Branco and Mark Swinburne