 Ask
Dr. Econ
February 2000
Should the government or the central bank be left in control of
interest rates?
A review of the literature indicates that independent central banks have
generally been more successful in reaching the goal of price stability
than central banks that were acting under the direction of the government
or the treasury. For example, in the abstract to his March 1995 NBER Working
Paper titled "Modern Approaches to Central Banking," Stanley Fischer,
of the International Monetary Fund stated:
The empirical evidence shows not only that greater independence is
associated with lower inflation, but also that the central bank's rights
not to finance government and set interest rates independently increases
its effectiveness.1
Independent central banks in many countries control monetary and interest
rate policies. In other countries, governments may exert direct or indirect
control over the central bank's monetary and interest rate policies. Differences
in goals and objectives between an independent central bank and a government
or treasury directed central bank may have significant monetary policy
and inflation implications.
The goal of a central bank usually reflects the desire to control inflation
and promote a healthy economy. For example, the Federal Reserve's goals
in conducting monetary policy are "to promote effectively the goals of
maximum employment, stable prices, and moderate long-term interest rates."2
The new European Central Bank's primary goal is to focus on price level
stability. When central banks' policies succeed, the government and the
public also benefit from the stable inflation rate and a healthy economy.
Structural independence and credibility also may be important for a central
bank. In the case of the Federal Reserve, there are several key structural
features that are designed to insulate monetary policy from political
pressures. First, the Governors are nominated by the President and confirmed
by the Senate to 14-year terms. Second, the Fed is self-funding; it is
not part of the budget process. In addition, Reserve Bank presidents are
selected by their own District Board of Directors and approved by the
Board of Governors. A central bank also must establish credibility with
the public in its ability to set a noninflationary course for monetary
policy. A central bank without credibility may have a more difficult time
reducing inflation because the public does not expect them either to do
so, or to be able to do so.3
The government and the treasury may have different goals from the central
bank. Government policymakers may be tempted to continuously boost economic
growth in the short-term, without considering the long-term inflationary
consequences. Meanwhile, the treasury's primary goal typically is to minimize
the cost of financing government debts. Lower interest rates on treasury
debt directly reduces the cost of borrowing. This debt funding need creates
an incentive for the treasury to prefer policies that lower interest rates
policies in the short-term. However, a treasury-driven policy that maintains
interest rates at a lower level (than the central bank might target) to
reduce treasury funding costs, runs the risk of overstimulating the economy
in the near-term, and causing inflation and interest rates to rise in
the long-term. Thus, allowing the treasury to determine monetary policy
may create an inflationary bias and reduce the credibility of the central
bank efforts to control inflation.
Historically, there was a period in the late 1940s and early 1950s in
the United States where the U.S. Treasury took the lead in setting monetary
and interest rate policy. During World War II and up until 1951, the Federal
Reserve agreed to maintain interest rates at relatively low levels to
assist the Treasury in financing the large volume of government debt generated
during that period. The Federal Reserve essentially gave up conducting
an independent monetary policy during this period to meet the Treasury's
desire to minimize the cost of financing its large outstanding debt. Inflation
rates were relatively high during much of this period. In 1951, the Treasury
and the Federal Reserve reached an accord, one that allowed the Fed to
once again focus on monetary policy.4
In the years after the accord, the U.S. inflation rate dropped sharply.
Finally, there is a considerable volume of literature on the benefits
of having an independent central bank that can conduct monetary policy
as it sees fit. This literature covers experiences from many time periods
and countries. Still, critics have noted that having an independent central
bank may not be sufficient to have low inflation--that a political consensus
supporting low inflation policies may be even more important.5
Several of the articles referenced below provide insights into the importance
of central bank independence in making monetary policy.
References
Cogley, Timothy. 1996. "Why Central Bank Independence Helps to Mitigate
Inflationary Bias." FRBSF Economic Letter 96-08 (February 23).
http://www.frbsf.org/econrsrch/wklyltr/wl9608.html
Board of Governors of the Federal Reserve System. 1994. The Federal
Reserve System Purposes & Functions. http://www.federalreserve.gov/pf/pf.htm
Fischer, Stanley. 1995. "Modern Approaches to Central Banking." National
Bureau of Economic Research, Working Paper #5064 (March). http://papers.nber.org/papers/W5064.pdf
Greenwald, Douglas, Editor in Chief. 1994. The McGraw-Hill Encyclopedia
of Economics. New York: McGraw-Hill, Inc.
Parry, Robert T. 1995. "Central bank independence and inflation." FRBSF
Weekly Letter 95-16 (April 21).
Posen, Adam. 1995. "Central Bank Independence and Disinflationary Credibility:
A Missing Link?" Federal Reserve Bank of New York Staff Reports
Number 1 (May).
Spiegel, Mark M. 1997. "British Central Bank Independence and Inflation
Expectations." FRBSF Economic Letter 97-36 (November 28). http://www.frbsf.org/econrsrch/wklyltr/el97-36.html
Walsh, Carl E. 1996. "Accountability in Practice: Recent Monetary Policy
in New Zealand." FRBSF Economic Letter 96-25 (September 9). http://www.frbsf.org/econrsrch/wklyltr/el96-25.html
1 Stanley Fischer, "Modern
Approaches to Central Banking," National Bureau of Economic Research,
Working Paper #5064 (March 1995). http://papers.nber.org/papers/W5064.pdf
2 Board of Governors of the
Federal Reserve System, The Federal Reserve System Purposes & Functions,
(1994), Chapter 2. http://www.federalreserve.gov/pf/pf.htm
3 Robert T. Parry, "Central
bank independence and inflation," FRBSF Weekly Letter 95-16 (April
21, 1995).
4 Douglas Greenwald, Editor
in Chief, The McGraw-Hill Encyclopedia of Economics, (New York:
McGraw-Hill, Inc., 1994), page 409.
5 Adam Posen, "Central Bank
Independence and Disinflationary Credibility: A Missing Link?" Federal
Reserve Bank of New York Staff Reports 1 (May 1995).
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