In undertaking financial reforms, it is important that we maintain and protect the aspects of central banking that proved to be strengths during the crisis and that will remain essential to the future stability and prosperity of the global economy. Chief among these aspects has been the ability of central banks to make monetary policy decisions based on what is good for the economy in the longer run, independent of short-term political considerations. Central bankers must be fully accountable to the public for their decisions, but both theory and experience strongly support the proposition that insulating monetary policy from short-term political pressures helps foster desirable macroeconomic outcomes and financial stability.
monetary theory and policy walsh solutions
The Case for Central Bank IndependenceA broad consensus has emerged among policymakers, academics, and other informed observers around the world that the goals of monetary policy should be established by the political authorities, but that the conduct of monetary policy in pursuit of those goals should be free from political control.2 This conclusion is a consequence of the time frames over which monetary policy has its effects. To achieve both price stability and maximum sustainable employment, monetary policymakers must attempt to guide the economy over time toward a growth rate consistent with the expansion in its underlying productive capacity. Because monetary policy works with lags that can be substantial, achieving this objective requires that monetary policymakers take a longer-term perspective when making their decisions. Policymakers in an independent central bank, with a mandate to achieve the best possible economic outcomes in the longer term, are best able to take such a perspective.
In contrast, policymakers in a central bank subject to short-term political influence may face pressures to overstimulate the economy to achieve short-term output and employment gains that exceed the economy's underlying potential. Such gains may be popular at first, and thus helpful in an election campaign, but they are not sustainable and soon evaporate, leaving behind only inflationary pressures that worsen the economy's longer-term prospects. Thus, political interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less stable economy and higher inflation.
Undue political influence on monetary policy decisions can also impair the inflation-fighting credibility of the central bank, resulting in higher average inflation and, consequently, a less-productive economy. Central banks regularly commit to maintain low inflation in the longer term; if such a promise is viewed as credible by the public, then it will tend to be self-fulfilling, as inflation expectations will be low and households and firms will temper their demands for higher wages and prices. However, a central bank subject to short-term political influences would likely not be credible when it promised low inflation, as the public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies that would be inconsistent with long-run price stability. When the central bank is not credible, the public will expect high inflation and, accordingly, demand more-rapid increases in nominal wages and in prices. Thus, lack of independence of the central bank can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment.3
These concerns about the effects of political interference on monetary policy are far from being purely theoretical, having been validated by the experiences of central banks around the world and throughout history. In particular, careful empirical studies support the view that more-independent central banks tend to deliver better inflation outcomes than less-independent central banks, without compromising economic growth.5 In light of all these considerations, it is no mystery why so many observers have come to see central bank independence as a critical component of a sound macroeconomic framework, and economists have studied a variety of approaches to enhance the independence and credibility of monetary policymakers.6
To be clear, I am by no means advocating unconditional independence for central banks. First, for its policy independence to be democratically legitimate, the central bank must be accountable to the public for its actions. As I have already mentioned, the goals of policy should be set by the government, not by the central bank itself; and the central bank must regularly demonstrate that it is appropriately pursuing its mandated goals. Demonstrating its fidelity to its mandate in turn requires that the central bank be transparent about its economic outlook and policy strategy, as I will discuss further in a moment. Second, the independence afforded central banks for the making of monetary policy should not be presumed to extend without qualification to its nonmonetary functions. For example, many central banks, including the Federal Reserve, have significant responsibilities for oversight of the banking system. To be effective, bank regulators and supervisors also require an appropriate degree of independence; in particular, the public must be confident that regulators' decisions about the soundness of specific institutions are not unduly influenced by political pressures or lobbying. But for a number of reasons, the nature and scope of the independence granted regulatory agencies is likely to be somewhat different than that afforded monetary policy. In the conduct of its regulatory and supervisory activities, the central bank should enjoy a degree of independence that is no greater and no less than that of other agencies engaged in the same activities; there should be no "spillover" from monetary policy independence to independence in other spheres of activity. In practice, the Federal Reserve engages cooperatively with other agencies of the U.S. government on a wide range of financial and supervisory issues without compromising the independence of monetary policy.
The case for independence also requires clarity about the range of central bank activities deemed to fall under the heading of monetary policy. Conventional monetary policy, which involves setting targets for short-term interest rates or the growth rates of monetary aggregates, clearly qualifies. I would also include under the heading of monetary policy the central bank's discount-window and lender-of-last-resort activities. These activities involve the provision of short-term, fully collateralized loans to the financial system as a means of meeting temporary liquidity needs, reducing market dysfunctions, or calming financial panics. As has been demonstrated during financial panics for literally hundreds of years, the ability of central banks to independently undertake such lending allows for a more rapid and effective response in a crisis. On the other hand, as fiscal decisions are the province of the executive and the legislature, the case for independent lender-of-last-resort authority is strongest when the associated fiscal risks are minimal. Requiring that central bank lending be fully secured, as is the case in the United States, helps to limit its fiscal implications. Looking forward, the Federal Reserve supports measures that help further clarify the dividing line between monetary and fiscal responsibilities. Notably, the development of a new statutory framework for the resolution of failing, systemically important firms is not only highly desirable as a means of reducing systemic risk, but it will also be useful in establishing the appropriate roles of the Federal Reserve and other agencies in such resolutions.
The issue of the fiscal-monetary distinction may also arise in the case of the nonconventional policy known as quantitative easing, in which the central bank provides additional support for the economy and the financial system by expanding the monetary base, for example, through the purchase of long-term securities. Rarely employed outside of Japan before the crisis, central banks in a number of advanced economies have undertaken variants of quantitative easing in recent years as conventional policies have reached their limits. In the United States, the Federal Reserve has purchased both Treasury securities and securities guaranteed by government-sponsored enterprises.
Although quantitative easing, like conventional monetary policy, works by affecting broad financial conditions, it can have fiscal side effects: increased income, or seigniorage, for the government when longer-term securities are purchased, and possible capital gains or losses when securities are sold. Nevertheless, I think there is a good case for granting the central bank independence in making quantitative easing decisions, just as with other monetary policies. Because the effects of quantitative easing on growth and inflation are qualitatively similar to those of more conventional monetary policies, the same concerns about the potentially adverse effects of short-term political influence on these decisions apply. Indeed, the costs of undue government influence on the central bank's quantitative easing decisions could be especially large, since such influence might be tantamount to giving the government the ability to demand the monetization of its debt, an outcome that should be avoided at all costs.
The Historical Evolution of Central Bank IndependenceSupport for the idea of central bank independence has evolved over time. In the United States and many other countries, the historically high and volatile inflation rates in the 1970s and early 1980s prompted a reexamination of monetary policies and central bank practices. Since that time, we have observed the confluence of two global trends: the widespread adoption of improved monetary policy practices and the virtual elimination of high inflation rates. The improved policy practices prominently include a broad strengthening of central bank independence, increased transparency on the part of monetary policy committees, and the affirmation of price stability as a mandated goal for monetary policy. Inflation targeting, in which the government sets a numerical target for inflation but assigns responsibility for achieving that target to the central bank, has become a widely used framework embodying these principles, but other similar monetary frameworks have also proved effective. 2ff7e9595c
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