The role of a central bank is filled with financial jargon. To the layman, however, the role of a central bank is simple – to make our lives easier. Wild price fluctuations and inflation complicate people’s lives. Central banks conduct monetary policy to manage economic fluctuations and keep price stability in check.
For nearly 40 years inflation targeting has been a leading foundation for monetary policy. Many countries have an explicit inflation target and central banks will adjust the supply of money in a given market to achieve the target. For example, a central bank could sell government bonds (sale and repurchase agreements) which would take in money from large commercial banks. This would effectively reduce the amount of money in an economy. A measure like this would steer short-term interest rates that in turn influence longer-term rates and economic activity as a whole.
Central bank independence has been broadly accepted. By maintaining a neutral stance, regardless of the political party in power, central banks can focus solely on inflation and employment and not be swayed by a politician’s timely desires. Yet, news from the UK and the Bank of England has some worriedly questioning whether advanced nations are wavering on central banking independence.
Liz Truss is one of the front-runners to become Britain’s next prime minister. If elected, she’s publicly promised to review the bank’s powers, most notably its ability to set interest rates without government interference. This statement came in the wake of the bank’s most recent interest rate hike (the most since 1995) and their forecast of a prolonged recession and eventual double-digit inflation. Politicians in power (or those about to be) generally don’t favor prolonged recessions and double-digit inflation.
Now, despite political outcries like that from Ms. Truss, overall the data suggests that central bank independence works. Between 1970 and 1999 governments with more independent central banks such as Switzerland, Austria, and Germany achieved lower inflation as compared to equally developed countries with less central bank independence – namely Spain, New Zealand, and Norway. Argentina’s central bank is tightly tied to the president. Inflation is closing in on triple digits and the Argentine peso has crumbled to half its value over the last 1 ½ years.
Covid, wars, and general disorder tend to move politicians to try and consolidate control. This can be either to hang on to their jobs or oust the pervading guy or gal from office. Central banks have historically dealt with this pressure but it appears to be advancing in some of the most developed economies on the planet. Should central banks begin to fall under political control outcomes like that of Argentina are a stark reminder of what could await. Central banks and those that value a separation of powers should be cautious in staying silent on the issue.
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