Central bank independence, price stability and inflation

02-02

As we know, one the the most significant goal of the central bank is price stability, and the role of central bank independence has been discussed all over the world in recent years especially since the successful reform of the Reserve Bank of New Zealand which gave the Reserve Bank greater independence from the central government. A the reform, New Zealand』s central bank now ranks among the more independent ones. Therefore, many people believe that increased central bank independence lead to lower inflation. However, this may not be exact.

What is central bank independence?

First, it is necessary to clarify what the central bank independence is. Independence in this context means the freedom of central banks to pursue monetary policies which are not dictated by political considerations of the government.

As for the central bank independence, David Ricardo (1824) once proposed to 「prevent all intercourse between these Commissioners and Ministers, by forbidding any species of money transactions between them」. This seems a little bit extreme today. Since the central banks derive their powers from government legislation, they cannot be completely separate from the government. Therefore, central banks cannot pursue monetary policies without any dictates by political considerations of the government.

The discussion nowadays is about the appropriate degree of separation between central banks and the government. It is impossible to preclude the government from commenting on monetary policies, and it is also impossible to preclude central banks from consulting with the government on monetary and other policies (B.W. Fraser, 1994).

Usually, the central bank independence includes two aspects: goal independence and instrument independence. Many factors including political considerations from the government can affect inflation targeting, and once the goal is determined central banks should have adequate tools to pursue the goals that they have set.

Importance of central bank independence for price stability

People always like price stability as well as economic growth, but these sometimes seem to be a little bit conflictive. Policy makers and politicians tend to push the economy to grow faster and further even beyond its capacity. Therefore, governments are willing to force their central banks to print excessive amount money or put in place policies that lead to higher inflation rates over time, which results in the inflation bias. To minimize this bias, many governments have adopted reforms aims at giving their central banks legal independence (CBI).

But do countries with independent central banks also have lower inflation? The reform of the Reserve Bank of New Zealand gives us a good example. Here we use the charts designed by Carlstrom and Fuerst (2006) to support our discussion.

Figure 1 shows that industrialized countries have achieved a remarkable decline in inflation: Their average annual rate dropped from 5.6% in 1955-1988 to 2.7% in 1988-2000. One of the most extraordinary countries is New Zealand, whose average annual inflation dropped from 7.6% in the earlier period to 2.7% in the later one. How much of this success can be explained by the increased independence of their central bank? Figure 2 demonstrates a strong relationship between independence and inflation for a group of countries in the earlier period especially for New Zealand.

Figure 1 Inflation of industrial countries

Figure 2 Independence, early period vs. late period

Notes: Charts above are designed by Carlstrom and Fuerst (2006).
Figure 1- a: All OECD countries except Turkey.
Figure 2 - a: For New Zealand, Spain, Italy, Belgium, France, Norway,

Australia, Sweden, U.K., Denmark, Japan, Netherlands, Canada, U.S., Germany, and Switzerland.
Figure 2 - b: For Austria, Greece, Hong Kong, Iceland, Ireland, Korea, Portugal, Singapore, Taiwan, and Finland.
Sources of data: International Labor Organization; Organization for Economic Cooperation and Development; Bloomberg Financial Information Services; Alesina and Summers, 1993; and Fry et al., 2000.

The key to price stability?

The above evidence shows a strong link between central bank independence and inflation. It seems that an independent central bank is a government』s most effective way to ensure delivery of a low inflation rate.

However, it is necessary to point out that the results above are for OCED countries, in other words, developed countries. There is some evidence that the link between central bank independence and price stability is much weaker for developing countries. Another important point is that central banks and monetary policies are not the only influences on inflation. It is possible that other forces or factors that affect inflation rates may obscure the positive effect of central bank independence on price stability.

Is it possible that it is their high economic growth or other factors which keep the price stable that make this country tolerate its independence of monetary policy? When the economy is healthy and grows fast, the negative effect caused by the inadaptability of the central bank independence to the economy growth may be hided.

Take the Bank of Japan as an example. Japan』s central bank has a low level of independence, but the inflation record of Japan is quite excellent. So we can say that increased central bank independence does not necessarily lead to lower inflation. This is because monetary policies, on their own, cannot guarantee to deliver lower inflation. For example, fiscal policies and wages policies made by the government also have a significant role on inflation outcomes.

There are no universal rules. For central banks, to pursue its goal of price stability, independence is desirable but this is neither a necessary nor a sufficient option. It is necessary to learn the experience from other central banks, but each country must establish its own legal framework for its central bank which best fit that country』s own history, institutions, and traditions.

Reference
[1] Alesina, Alberto; and Summers, Lawrence H. 「Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.」 Journal of Money, Credit, and Banking, Vol. 25, No. 2, May 1993, pp. 151-62.
[2] B.W. Fraser. 「Central Bank Independence: What Does It Mean?」 Reserve Bank of Australia Bulletin, November 1994.
[3] Carlstrom, C. T., and Fuerst, T. S. 「Central Bank Independence: The Key to Price Stability.」 Federal Reserve Bank of Cleveland. Economic Commentary, September 2006, pp.1-4.