Stefan Gerlach | The limits of central bank independence

Central banks are not sovereign principalities, and their governors are not sovereign princes. While central bank independence has been essential to effective policymaking in recent decades – giving monetary authorities the political cover to pursue necessary but potentially painful measures when conditions demand – the limits of the principle are almost certain to become clearer in the coming years.

The reason is not that there have been catastrophic monetary policy mistakes, or that governments want to manage monetary policy themselves. Central banks have generally done a good job, and governments are happy to let them do it.

While the US Federal Reserve and other central banks certainly could have stepped in earlier to stop or mitigate the recent surge in inflation, most sober observers regard that episode as unavoidable. It was caused by a series of extraordinarily large and entirely unexpected shocks to the world economy – not least COVID-19 and Russia’s invasion of Ukraine. Central bankers can be forgiven for not anticipating the first global pandemic in a century and the first major war in Europe in 80 years.

So, why is the principle of central bank independence becoming more vulnerable? The main concern is the growth of central banks’ balance sheets – owing to years of quantitative easing – which are now leading to large losses.

While central bank independence is fine for governments, in principle, losses that will have first-order effects on public finances are another matter. And this is especially true if losses are materialising at a time when demand for public spending on climate change adaptation and mitigation, strategic competitiveness, and defence has increased massively.

Central bank independence is often seen as a panacea to the type of high and persistent inflation that characterised the 1970s and early 1980s. To many, it looks like a free lunch: disinflation and long-term price stability without any adverse effects on growth and unemployment. But defenders of central bank independence have almost certainly overestimated its role as a guarantor of low inflation.

Consider a counterfactual: the Monetary Authority of Singapore, MAS, has achieved an average inflation rate of almost 2.0 per cent since its monetary policy framework was introduced in the early 1980s. Few central banks can match this stellar record, and yet four government ministers sit on the MAS’s board, and there is little doubt that the Singaporean government can control monetary policy if it so wishes. Singapore has achieved consistently low, stable inflation without a robust regime of central bank independence.

What matters most for price stability is the central bank’s ability to set interest rates and other policy levers as it sees fit. Firm political support for the objective of maintaining low inflation is essential; but complete legal independence does not seem to be a necessary condition for achieving it.

Moreover, when economists quantify central bank independence, the Fed itself scores poorly – worse than central banks in many inflation-prone Latin American countries – yet it is generally regarded as doing a good job of ensuring price stability. Again, the key question is whether there is a political consensus against meddling in the central bank’s pursuit of low inflation.

Central banks are quick to point out that their objective is to ensure stable prices, not to generate government revenues. While this claim is certainly true, it is a little naive. When central bank independence was embraced around the world a quarter-century ago, no one anticipated that central banks’ profits and losses would matter much for public finances.

But large losses do matter, and since the situation has changed, politicians might come to believe that the consensus behind central bank independence and the form it takes also need to change.

Governments hold the power to appoint monetary policymakers, so it stands to reason that they will not appoint officials who are tone-deaf about government interests and priorities. This is why central bank governors in many countries are often drawn from the ranks of former treasury officials.

Central banks would do well to be more sensitive to the consequences that their actions may have on public finances. Ultimately, that may be the only way to protect their freedom to align monetary policy with their price stability mandate.

Stefan Gerlach, Chief Economist of EFG Bank in Zurich, is a former executive director of the Hong Kong Monetary Authority and a former deputy governor of the Central Bank of Ireland. © Project Syndicate 2024www.project-syndicate.org