The financial crisis and its aftermath have raised questions about central banks and their mandates.
In the past three decades, central banks adopted price stability as their sole goal. This led to the rise of inflation targeting as the key to monetary policy, and of its corollary, central-bank independence from political interference.
However, the financial crisis forced central banks to pay less attention to inflation and to implement unconventional policies to achieve additional tasks. This brought about a quest for redefining central-bank objectives and cast doubt on the appropriateness of independence.
A couple of forces contributed to the decline of inflation targeting. First, it missed the asset and commodity bubbles and the growing instability in the banking system before the financial crisis. Second, with advanced economies in a recession and struggling to reduce unemployment and to restore growth, central banks have been called on to deal with these imbalances.
Against this backdrop, one should question whether inflation targeting is effective during times of stress, and more broadly, if it is a sustainable framework for working through economic cycles. Indeed, one should be skeptical of the legitimacy of a regime that zeroes in on a single goal only as long as things are normal. One also should be forgiven for wondering if an inflation target that can be set aside during a crisis really counts as inflation targeting at all.
Stable prices are no longer the sole target of central banks in advanced economies. The Federal Reserve has all but adopted an employment target and there is much talk about targeting nominal gross domestic product and other benchmarks. Moreover, financial stability is again a central-bank responsibility, for the Fed as well as the European Central Bank.
Many observers have recently claimed that this shift to multiple targets leads to a loss of central-bank independence. The argument is that pursuing employment and growth targets and providing financing directly to the economy are political decisions that can’t be made by unelected officials. Moreover, quantitative easing, by pushing interest rates toward zero, has strong, and usually regressive, income-distribution effects, leading to widening inequality. Such central-bank incursions have powerful political implications and undermine the case for independence.
This argument isn’t fully consistent. Although it is true that multiple targets tend to increase the political consequences of central-bank decisions, concentrating only on fighting inflation also has distributional -- and therefore, political -- implications. Politicized central banking is a matter of degree and scale, not a real transformation.
The justification for central-bank independence was rooted in two ideas. The first has to do with timing: Monetary policy has expansionary effects in the short run but inflationary consequences in the long run, and this can be exploited by politicians during elections. The second is that central banks are better suited than other policy makers or political leaders to dealing with monetary issues. For the most part, central banks can be trusted to pursue their goals without political pressure.
However, the adoption of multiple targets cancels both rationales. Central banks don’t have an advantage in other policy objectives, aside from fighting inflation. So there is no strong reason to give central bankers latitude in the design and implementation of policies.
Since multiple objectives are here to stay for central banks, we should expect steady erosion in their independence. There are some positive aspects to this development. It restores balance to decision making and helps policy coordination, particularly in times of economic stress. It does require, however, that political interference should be restricted. Therefore, rather than bemoan reduced independence, it would be useful to develop a transparent framework with well-defined and clear rules.
An important caveat applies to emerging markets. Independent central banks and inflation targeting were, in most of developing countries, sound instruments for fighting inflation. These central banks also fulfilled another critical role: institution building.
Central-bank independence is a peculiar construct. In today’s economic setting, though, preserving this paradigm may result in outcomes at odds with democracy. Whether desirable or not, central-bank independence will weaken. We had better be ready to deal with that.
(Mario I. Blejer is a former governor of Argentina’s central bank, was a senior adviser to the International Monetary Fund and is currently the vice chairman of Banco Hipotecario SA. The opinions expressed are their own.)
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