Central bank independence was a key trend in developed economies during the 2000s. This reduced susceptibility to short-term political pressures has been seen as a key reason for consistently low inflation in these economies compared to the levels seen during the Great Inflation lasting between 1965 and 1984.
Nuanced approach needed to central bank independence
In response to the global financial crisis, central banks across the world have been given greater independence and powers (e.g. prudential regulation of banks). It is largely assumed that greater independence would continue to deliver economic benefits.
But a recent paper by former minister and unlikely reality show star Ed Balls argues for a more nuanced approach to thinking about central bank independence. This is significant given that Ed Balls is according to the FT «one of the chief architects of UK central bank independence».
In particular, a distinction is drawn between political and operational independence.
Operational independence is generally defined as the freedom of the central bank to select and use various instruments to achieve their policy goals.
The report undertook an analysis using linear regression on operational independence scores and inflation rates across 22 advanced economies, controlling for other variables that may reflect country-level factors. It found a statistically significant negative relationship between inflation and operational independence. Increased operation independence does indeed contribute to lower inflation.
Political independence is largely understood to be the degree of influence that elected politicians have over the central bank. Goal independence — the ability of central banks to set their own policy goals — has been subsumed under political independence for the purposes of this research.
A similar linear regression analysis was undertaken on political independence scores and inflation rates. This time however no statistically significant relationship was found. There is no evidence that increased political independence contributes to lower inflation rates.
Central banks do not operate in a political vacuum. They are affected by Government policy, their decisions come under political scrutiny, and their actions have political effects.
They also play an increasingly pivotal role in our economies. Whilst central banks have been granted far greater independence and powers over the last few decades, it is important to periodically review these powers and any underlying assumptions.