Central Banking Part Two: Why Independence?

Discussion and Analysis by Charles Porter: 

How important is Central Bank Independence?


The German model of central banks has triumphed on the European continent, manifested within the European Central Bank, ECB, at least as far as institutional design is concerned. The US Federal Reserve, FED, is slightly less, yet comparably, independent. The Bank of England, BoE, is the least independent. But what does this really mean?


As mentioned within Part One of this analysis, central bank independence can be inversely correlated with accountability. This is a logical relationship because (political) distance is a form of critical insulation. This is clearly a negative attribute to the characteristic of independence which is typically deified.


Despite accountability concerns, independence precludes political involvement in the setting of monetary policy. This means that, for example, preceding a national election, the incumbent party cannot artificially pursue expansionary monetary policy to precipitate economic growth thereby fostering political support. Whilst this may be justified in terms of pure equitability, it is also crucial, according to the ECB, to prevent long-term economic sabotage.


From the perspective of currency markets, it similarly awards confidence in greater exchange rate stability. Interest rates have an immense importance upon the relative valuation of an exchange rate due to the increased/decreased reward for saving or holding the currency that it entails. Therefore, central bank independence leads to confidence that short-term, economically inefficient and volatility inducing manipulations will not occur.


Inter-currency relative central bank independence is similarly important. The ECB is more independent than its US and UK counterparts due to the need to defend itself from idiosyncratic national political monetary-policy demands. Should the ECB architecture not include the necessary safeguards against political dependence, the prioritisation of one country’s monetary policy desires could entail an exceptionally harmful monetary pursuit for another economy. Therefore, to some extent, the outstanding relative independence of the ECB promotes the longevity of the European project: the Eurozone could never survive should the ECB be politically influenceable.


The FED, the US central bank, similarly manages a currency union; the Dollar. So, one might ask why does it not need a comparable independence to the ECB. The complementarity between the architecture of the FED and the superior political and cultural integration within the US is likely to address this question. However, crucially, the FED’s superior independence compared to the Bank of England advances the relationship between monetary unification and central bank independence. Although we have a tendency to forget, the UK is too a monetary union across nations. Harmony is easier to foster as borders become more invisible. Therefore, it may be the case that the complementarity between the architecture of the BoE and the integration of its nations’ citizens facilitates an even lower level of independence.


Tomorrow, we will see 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 in Wyoming. Our economic analysis will be guided by this understanding of the constraints and responsibilities, determined in part by independence, that the leader of both institutions embodies. An in-depth understanding of the sentiment behind their speeches can subsequently be obtained.