M-RCBG Associate Working Paper No. 67
Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like?
Ed Balls, James Howat, and Anna Stansbury
(An updated version of this paper is available. See Paper No. 87.)
In the aftermath of the global financial crisis, countries around the world have dramatically expanded the objectives and powers of central banks beyond their traditional inflation targets and policy rates. But as these unelected, technocratic, institutions become increasingly powerful, the pre-crisis academic consensus around central bank independence – put crudely, ‘the more, the better’ – has become inadequate. Absolutist interpretations of complete central bank independence may both undermine the pursuit of new central bank objectives and fray the political support that currently exists for central bank autonomy in their core monetary policy function. Indeed, popular discontent towards central banks is growing in the US, UK and the euro-zone. We need a more nuanced approach to central bank independence in this brave new world.
There are elements of the pre-crisis consensus that must be protected. We show that operational independence of central banks – the ability to choose an instrument to achieve inflation goals - has been associated with significant improvements in price stability. But, in advanced economies at least, political independence – the absence of any possibility for politicians to influence central bank goals or personnel – is not correlated with inflationary outcomes. In order to protect their popular legitimacy, central banks in advanced economies can therefore sacrifice some political independence without undermining the operational independence that is important in both their monetary policy and financial stability functions.
In light of this distinction between political and operational independence, this paper then evaluates the new powers that central banks have taken on over the last few years, focusing on advanced economies. Our framework examines how to maximize the benefits of locating new powers inside the central bank, while minimizing potential conflicts with monetary policy and limiting political threats to the legitimacy of central banks’ operational independence.
The recent US election, and the resulting Republican control of Congress as well as the White House, are widely expected to lead to further criticism of the power and independence of the Federal Reserve. Meanwhile, in recent weeks we have seen increasingly open political attacks on Bank of England Governor Mark Carney from Brexit supporters. But we are clear that this is no time to throw the baby out with the bathwater. We do argue for a more nuanced approach to central bank independence, with political accountability in terms of mandate-setting and appointment of officials, and oversight of wider financial stability powers. Nonetheless, we reiterate that the case for operational independence in both monetary and macro-prudential policy is strong: to retreat on this now would be a serious mistake.