Central bank independence and price stability

There is a broad consensus within economics, based on both economic theory and empirical evidence, that central bank independence is a necessary condition for low and stable inflation. The idea behind CBI is a simple one: without it, elected politicians are likely to “bribe” voters by lowering interest rates before elections. Such reductions in interest rates will increase employment and output temporarily, but at the cost of permanently higher inflation. The backbone to this prediction is the notion that there is no permanent trade-off between inflation and unemployment, typified by a vertical Phillips curve (see Box 2.1).

In a world in which economic agents are rational, if monetary policy is in the hands of government, inflation targets will not be credible and an inflation bias will be created. Only by delegating monetary policy to independent central bankers is there a hope to remove inflation bias from the economy. CBI provides the foundations for low and stable inflation. On its own, however, it is not a sufficient condition. To start with, there are various degrees of independence. A central bank may have operational independence over the setting of policy rates but very little else. It may, for example, be compelled to finance government deficits – a situation described as fiscal dominance. Under this scenario, the job of getting inflation under control can become a poisoned chalice. It means that the central bank should raise interest rates much more than would normally be the case, in order to curb the effects of fiscal profligacy on aggregate demand through crowding out private investment and consumption.

Ideally, therefore, central banks must be independent enough to be able to refuse the financing of government deficits. Even so, to keep inflation under control, central banks must have a communication framework in place that helps them explain monetary policy decisions in a clear and transparent manner. The credibility of monetary policy and any inflation targets critically depends on such communication.

In Europe, the architects of the Economic and Monetary Union (EMU) recognized the importance of central bank independence for the achievement of price stability and placed both at the heart of their project.