The Erosion of Central Bank Independence

The Issue:

The trend over the past 40 years has been towards increased legal independence for central banks. There is near-unanimous agreement among economists that this is a favorable development, as independence insulates the central bank from pressure to stimulate the economy for political gain, which eventually tends to increase inflation. This view is supported by the data, as banks with a greater degree of independence typically experience lower inflation. The road towards greater autonomy is not one-way, however. Amendments to central bank laws or mandates have on occasion impinged on their autonomy. And in a few cases, the autonomy of legally independent central banks has been undermined by executive branch overreach, such as when central bank governors have been dismissed or pressured to resign for failing to acquiesce to government policies. Is legal independence sufficient to ensure low inflation? What conditions lead to an erosion of autonomy? And how does the loss of de facto autonomy affect economic outcomes?

What conditions lead to an erosion of autonomy? And how does the loss of de facto autonomy affect economic outcomes?

The Facts:

• There are many different legal dimensions to central bank independence. One key aspect is goal independence — who sets the policy goals: the central bank itself, or the elected government. A related element is the nature of the bank’s legal mandate, either established in the central bank law or in a separate agreement. Specifically, the issue is whether the mandate is limited to price stability, to the exclusion of other objectives, such as full employment or exchange rate stabilization. Academic research suggests that central banks whose mandate is exclusively price stability are the most insulated from political pressure and hence have the highest degree of goal independence. 
• In the United States, the Federal Reserve has substantial, but not complete, goal independence. Congress, through the Federal Reserve act and subsequent amendments, gives the Fed the multiple objectives of “maximum employment, stable prices, and moderate long-term interest rates.” The Fed is free to determine how these broad objectives translate into specific targets, however. The Fed has interpreted the “stable prices” goal as corresponding to a 2% inflation rate, and treats “moderate long-term interest rates” as equivalent to price stability. The Bank of England has less goal independence than the Fed, as its 2% inflation target is set by the government, rather than by the Bank.
• Countries do, on rare occasions, curtail the central bank’s statutory goal independence through democratic processes. For example, under the Labor party, the Reserve Bank of New Zealand (RBNZ) Act was amended in 2018 to add the goal of “maximum sustainable employment.” Three years later, in 2021 the central bank’s remit was modified to require the RBNZ to “assess the effect of its monetary policy decisions on the Government’s policy to support more sustainable house prices.” The reference to the government’s policy in particular raised concerns about an erosion in the Bank’s independence. New Zealand’s inflation track record following these changes is relatively short (the Bank returned to an inflation-only mandate in 2023) so it is hard to assess the changes’ impact on inflation. It is nevertheless worth noting that the increase in New Zealand’s inflation rate during and in the aftermath of the Covid-19 pandemic was no greater than in other countries, such as the United Kingdom, which had an inflation-only mandate. 
• Job security for policy makers is another key dimension of central bank independence. In countries whose legal frameworks confer a high degree of independence, the members of the committee with the power to set monetary policy (especially the Governor or Chair) can, at least in theory, only be dismissed “with cause,” such as corruption or the inability to discharge the duties of the office. (For example, the Governor of the Bank of Finland was dismissed in 1983 due to chronic alcoholism.) Disallowing the discretionary without-cause dismissal of bank governors frees central banks to pursue their mandated goal(s) without threat of interference or retribution.
• It is hard to find any instance in which statutory job security has been undercut legislatively. However, presidents have, on occasion, wielded executive power to either fire a central bank governor or pressure him to resign. Türkiye is a classic example. Exercising the power granted him by the new constitution, President Tayyip Erdoğan issued a decree in 2018 that deleted the clause in the central bank law that established a five-year term for the governor. The amendment allowed Erdoğan to fire Governor Murat Çetinkaya in 2019 for refusing to acquiesce to demands to lower interest rates. Erdoğan went on to dismiss two more governors over policy disagreements: Murat Uysal in 2020 and Naci Agbal in 2021. Inflation, which had averaged 14% in 2017-18 (the two years before Çetinkaya’s departure), rose sharply, to 63% in 2022-23.
• Argentina’s 2010 experience is another example of presidential pressure being brought to bear to influence central bank policy. According to that country’s central bank law, the removal of the governor is permitted only in the case of misconduct or failure to comply with the duties of a public official, and requires the consent of a commission charged with making such a determination. President Cristina Fernández de Kirchner nevertheless unilaterally dismissed the Governor, Martín Redrado on January 7 for refusing to divert the central bank’s reserves to service the country’s external debt. Redrado challenged the dismissal in court but eventually resigned on January 29. Inflation, which had already been running at over 20%, continued to rise, and surpassed 50% by the end of the decade.
• The central banks of Türkiye and Argentina had high scores for statutory independence during the relevant periods. In fact, based on measures derived solely from legal status, the two countries’ central banks ranked considerably higher than New Zealand’s. However, New Zealand’s governmental institutions were far stronger than Türkiye’s and Argentina’s. New Zealand ranked in the 93rd percentile on the World Bank’s “Government Effectiveness” indicator in 2018. (The United States was in the 88th percentile as of 2023.) Türkiye’s score was near the median in 2019, having fallen from the 68th percentile following Erdoğan’s election in 2014. Argentina’s score was close to the median in 2010 when Redrado was dismissed. The fact that Türkiye and Argentina suffered from high inflation despite their high marks for statutory independence suggests a link between monetary autonomy and institutional strength more broadly.
• Institutional strength matters for inflation—even taking statutory independence into account. This conclusion emerges from an analysis of the relationship between inflation and a measure of government quality — the World Bank’s Government Effectiveness indicator — for 150 countries over the period 2000-2023. I transformed the inflation rates to attenuate very high inflation values and controlled for statutory central independence (see here for full details). I find a clear inverse relationship, as illustrated in the chart: countries with strong institutions tend to experience low inflation, and weak institutions are typically associated with higher inflation, even after taking into account the degree of legal central bank independence.