Should the government or the central bank be left in control of interest rates?

February 1, 2000

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.


Cogley, Timothy. 1996. “Why Central Bank Independence Helps to Mitigate Inflationary Bias.” FRBSF Economic Letter 96-08 (February 23). /econrsrch/wklyltr/wl9608.html

Board of Governors of the Federal Reserve System. 1994. The Federal Reserve System Purposes & Functions.

Fischer, Stanley. 1995. “Modern Approaches to Central Banking.” National Bureau of Economic Research, Working Paper #5064 (March).

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). /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). /econrsrch/wklyltr/el96-25.html


1. Stanley Fischer, “Modern Approaches to Central Banking,” National Bureau of Economic Research, Working Paper #5064 (March 1995).

2. Board of Governors of the Federal Reserve System, The Federal Reserve System Purposes & Functions, (1994), Chapter 2.

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).