Central Banking Part One: What independence?

Discussion and Analysis by Charles Porter: 


How independent are Central Banks?


As the chair of the FED’s Board of Governors, Janet Yellen, and president of the ECB, Mario Draghi, meet together at the Jackson Hole symposium tomorrow, it is important to understand the relative roles and stature of each central bank.


The German model of central banks has triumphed on the European continent, at least as far as institutional design is concerned. But how independent are modern day central banks across the globe? The motivation for central bank independence primarily derives from credibility. Central Bank independence, understood as political independence, refers to the inability of political-motivations to manipulate the state of the economy through monetary policy. When it comes to the central bank of a monetary union, the implications, whilst more severe, stem from similar lines.


The European Central Bank, ECB, boasts of its guaranteed institutional, personal, functional, financial and legal independence. Independence is thought to be inversely correlated with accountability (see Part Two). It claims to restore its accountability through a direct link to EU citizens, a common theme throughout the European project, that ultimately only those citizens can be the arbiters of. Since its inception, guided by the 1992 Maastricht treaty, it has followed (and exaggerated) the German model.


This is unsurprising given credible research coming out of the University of Michigan that the construction of the European currency union was dominated by the preferences of the German government. The Bundesbank, although now entwined within the European System of Central Banks, was previously quantified as the world’s most independent central bank. Due to the international, inter-sovereign, composition of the Eurozone, it is unsurprising that political independence is so exaggerated. Independence follows its scope and mandate encompassing only treaty-enshrined price stability.


The Federal Reserve, FED, system operates through a Board of Governors. Targeting three macroeconomic goals, the FED’s independence is diluted. By convention and numerous quantification techniques, the FED’s independence remains strong. However, its independence remains inferior to that of the ECB. As will become clearer within the second part of this article, the FED manages to remain more accountable than the ECB through its relative political dependence. This represents a challenging trade-off.


The Bank of England’s, BoE, independence was developed in 1997 under the chancellorship of Gordon Brown. The substance of its new independence was freeing the Bank to set its own interest rates in order to target a politically-set long-term inflation rate. Monetary instruments are revised under a Policy Committee which meets eight times each year. A mandate for macroeconomic management outside of the price level again questions the independence of the BoE. Prior, to 1997, its independence was far inferior to the US Federal Reserve Bank and the BoE’s current independence threshold.


Listed above in order of independence, the ECB, FED and BoE, are all highly independent in comparison with less developed world economies. However, the considerable disparity within the independence of the central banks of three major (reserve) currencies lead to an important question: how important is Central Bank Independence?