"Central Bank Independence Revisited in the Era
of Unconventional Monetary Policy"
Speech by
Professor John (Iannis) Mourmouras
Deputy Governor, Bank of Greece
Former Finance Minister
at the SEACEN1 - OMFIF Joint Policy Summit entitled
"Financial stability in an uncertain global environment"*2
Sasana Kijang, Bank Negara Malaysia
Kuala Lumpur, Malaysia
Wednesday, 23 November 2016
Ladies and Gentlemen,
It is a great honour for me to be back to this part of the world. It's certainly warmer over here!
I would like to thank the organisers for inviting me to give a speech at this Joint Policy
Summit on a topic that I have been revisiting lately, that of central bank independence. My
earlier research on the subject goes back 20 plus years.
My speech today revolves one single important question: if and how the concept of an
independent central bank has been challenged, or perhaps even undermined, in an era of
unconventional monetary policies, including their own exit strategies.
Quite a few examples come to mind, especially looking at the latest developments. US
President-elect Donald Trump criticised Fed Chair Janet Yellen for the Fed's policy of low
interest rates. In particular, the Fed has been accused of bias by President-elect Trump. British
Prime Minister Theresa May came openly against the Bank of England's policy under
Governor Mark Carney saying that low interest rates deprive savers of interest income. Also,
Germany's "five wise men" (Council of Economic Experts) and German Finance Minister
Wolfgang Schäuble criticised ECB President Mario Draghi for his negative interest rate
policy. Against this background, the ultimate question is quite straightforward: is central bank
independence sufficient for price stability when the tail risk of deflation is visible and
unconventional monetary policies last too long? Opinions differ on this and I will give you
my own view on this question in a minute, but before that let me make my view clear that
central bank independence is a necessary condition for price stability both in terms of
mitigating a political business cycle, but also in terms of reducing the inflationary bias
inherent in monetary policy.
Central bank independence: theory
The intellectual roots of central bank independence (or CBI) can be traced back to the
rational expectations revolution, pioneered by the Chicago School in the 1970s. Rational
expectations played a vital role in breaking the intellectual deadlock in the effort to address
the stagflation phenomenon of the 1970s. With regard to monetary policy, seminal work by
Kydland and Prescott (1977) and Barro and Gordon (1983) showed that under discretionary
monetary policy the interaction of rational private agents with an equally rational government
optimising a non-linear loss function whose arguments are deviations of inflation and output
from socially desired target-levels, generates a Nash equilibrium involving an inflation bias
whose size increases with the degree of output-gap aversion and which does not entail any
sustainable output gains.
To address the problem of inflation bias, monetary policy should be conducted under a
technology of credible commitment to low future inflation rates so that private inflation
expectations are anchored to equally low levels. Initially, this commitment took the form of
intermediate policy targets, such as targets for money supply growth, introduced in the early
1980s by the Reagan and Thatcher governments in the US and the UK respectively; or
exchange rate targets implemented, among others, by European countries in the context of the
European Monetary System. Intermediate targets were successful in lowering inflation in
major industrialised economies, thus introducing the Great Moderation era. However, the
instability of money demand and the opaqueness of money supply targets rendered the latter's
implementation operationally difficult (see Mourmouras and Arghyrou, 2000). On the other
hand, exchange rate targets rarely stood the test of time, thus preserving questions of
credibility, as demonstrated by the literature on currency crises (see Obstfeld, 1996).
CBI, along with the introduction of inflation targeting, was largely the profession's
response to the shortcomings of intermediate targets. Specifically, delegating monetary policy
to an independent central bank, with a formal mandate to achieve price stability and granting
discretion in the choice of instruments necessary to meet this objective, reduces the inflation-
bias problem as a result of the central banker's objective function including an inflation-
aversion parameter higher than the government's. Theoretically, this inflation gain may come
at the cost of higher output volatility (see Rogoff, 1995). Empirical evidence, however, (see
e.g. Alesina and Summers, 1993 and Cuckierman, 2008) suggests that CBI may operate as
free-lunch, in the sense that it involves an obvious gain without causing an equally obvious
loss. Empirical measures of central bank independence are found to be negatively correlated
with the first and second moment of inflation, showing little, if any, correlation with output
variability. Furthermore, CBI can be beneficial in ensuring sustainable public debt dynamics,
as theoretically shown by Mourmouras and Su (1995) in a dynamic game set-up. As a result
of its theoretical and empirical advantages, CBI was widely adopted (particularly in the
1990s) in major industrialised economies and beyond. The form of independence, however,
varies between instrument (economic) and goal (political) independence (see Fischer, 1995).
Under the former, the operational goals of the central bank are exogenously determined, either
by legislation or by another official body such as the finance ministry. Under instrument
independence, the central bank is free to choose without external interference the means (the
policy instruments) best suited to meet its given goals: the Bank of England is an example of
this form of independence. Under goal independence, the central bank chooses independently
both the goals of its policy, as well as the instruments best suited to meet its self-selected
goal: the ECB is an example of this type of independence.
Delegating monetary policy to an independent central bank raises important questions
of democratic checks and balances, i.e. questions of transparency and accountability.
Accountability, in turn, is related to at least two dimensions. First, the type of central bank
independence: the closer we move towards the independence goal, the higher the need for
transparency and accountability. The second dimension is the number of goals set for the
independent central bank. Perhaps non-intuitively, accountability declines with the number of
policy goals, as given a set of policy instruments, increasing the number of goals results in
trade-offs between goals. As the welfare ordering of policy outcomes under trade-offs is
intrinsically more difficult than performance-ordering under a single policy objective, the
scope for accountability increases when the central bank focuses on one policy objective. This
accountability enhancement, combined with the theoretical and empirical advantages of
inflation-averse monetary policy, resulted in the majority of the countries adopting central
bank independence to define price stability as the overriding objective of monetary policy.
The ECB is a characteristic example of this trend. On the other hand, the Fed, whose dual
mandate includes price stability and maximum employment (plus moderate long-term interest
rates), is a notable exception.
Monetary policy in the post-crisis period
The global financial crisis of 2008/2009 and the ensuing European sovereign debt
crisis have fundamentally changed the operational framework of independent central banks.
These changes relate to three levels. The first is methodological: We now have an
appreciation of the potential real economic costs of financial crises that we previously lacked.
This has motivated the development of a niche literature introducing a banking sector into
DSGE models, thus allowing for financial crises (see e.g. Gertler et al., 2012 and Boissay et
al., 2013). This literature promises to enhance the information available to policy-makers
designing and implementing monetary policy.
The second change is that central banks have been given new macro-prudential tasks,
such as the supervision of systemic banks in the EMU, conducted by the ECB since 2014. On
this frontier, central banks don't know if they have failed until is too late. The costs of
confusion and policy conflicts with multiple objectives may be too high, damaging the
credibility of the central bank. And I refer to both types of costs: the costs of taking measures
to avoid bank failures or the costs of doing nothing.
The third change is the situation on the ground: Rather than preventing excessive
inflation, price stability in the post-crisis era is about preventing deflation. Under low
inflation, central banks largely lose the main policy instrument of conventional (standard)
monetary policy, namely targeting short-run interest rates through open market operations, as
short-term rates are restricted by the zero lower bound limit. As a result, all major central
banks have employed non-standard monetary policy tools in recent years. These include the
provision of emergency liquidity and credit support to banks and other financial institutions,
extending the definition of assets accepted as eligible collateral when providing financial
institutions loans on a short- or medium-term basis; and introducing quantitative easing (QE)
programmes in the context of which central banks have been buying from the private sector
sovereign bonds, corporate bonds and other corporate assets.
Let me quickly remind you of the ECB's monetary policy stance over the last nine years
as a response to the worst financial crisis since the Great Depression, leading to negative
interest rates and entering practically unchartered territory.
Table 1. ECB's non-standard measures
Year Non-standard measures
Oct-Dec 2008 ECB cuts the base interest rate from 4.25% to 2.50%, provides US dollar liquidity
through foreign exchange swaps, expands the list of assets eligible as collateral in
Eurosystem funding operations, introduces the 6-month longer-term refinancing
operations (LTROs) and decides the main refinancing operations to be carried out
through a fixed-rate tender procedure with full allotment.
2009 ECB cuts the base interest rate from 2.50% to 1.00%, and introduces the first Covered
Bond Purchase Programme (CBPP1).
2010 ECB activates the Securities Markets Programme (SMP).
2011 The ECB launches the second Covered Bond Purchase Programme (CBPP2) and
introduces the 3-year LTROs.
2012 The ECB announces the Outright Monetary Transactions (OMTs).
2013 The ECB cuts the base interest rate to 0.25% and introduces forward guidance.
2014 The ECB cuts the base interest rate to 0.05% and the deposit facility rate to -0.20%,
bringing it for the first time in negative territory and introduces the Targeted
LongerTerm Refinancing Operations (TLTRO) with a 4-year maturity.
2015 ECB introduces the expanded Asset Purchase Programme (APP) and cuts the deposit
facility rate to -0.30%.
2016 ECB accelerates the expanded Asset Purchase Programme (APP) and cuts the Main
Refinancing Operations (MRO) rate to 0.00% and the deposit facility rate to -0.40%.
Indeed, the 10 largest central banks now own assets totaling $21.4 trillion, accounting
for 29% of the world economy, up by 10% from end-2015, double what it was in mid-
September 2008 and almost half the value of all debt in Bloomberg's global bond index (as
shown in Chart 1)!
Chart 1. The combined assets of the 10 largest central banks
Finally, almost 75% of the world's central bank assets are controlled by policy-makers
in four regions: China, the US, Japan and the eurozone. The following six - that is, the central
banks of England, Brazil, Switzerland, Saudi Arabia, India and Russia - each account for an
average of 2.5%. The remaining 107 central banks tracked by Bloomberg, mostly with IMF
data, hold less than 13% (see Chart 2).
Chart 2. Central banks' combined assets
Chart 3. Stock of assets purchased by the four major central banks as a percentage of
national GDP
Source: Bank of Greece, European Central Bank, Fed, Bank of England and Bank of Japan. Note: The ECB's
purchased assets in the context of the SMP, CBPP1, 2 & 3, ABS and PSPP.
As a result, central bank balance sheets expanded considerably: since 2008 the Fed's balance
sheet has more than doubled; the Bank of England's balance sheet trebled; while the ECB's
balance sheet has also expanded considerably, particularly since the introduction of the ECB's
QE programme in 2015.
QE programmes are designed to prevent deflation mainly through three distinct channels (see
Demertzis and Wolff, 2016). First, the interest rate channel: this operates through lowering
long-term interest rates to improve investment conditions and disincentivise savings. Second,
the portfolio rebalancing channel: this operates through the purchase of relatively low-risk
assets of long-term maturity, thus incentivising investors to take long positions in higher-risk
(and thus higher expected return) assets. Third, the exchange rate channel, which as its name
suggests works through a demand-boosting weaker domestic currency. The degree of success
of QE programmes is under active research investigation Existing evidence, however,
suggests that they have been successful in preventing large-scale deflation conditions, with
the announcement effect of QE programmes being stronger than the effects of actual
implementation (see e.g. Demertzis and Wolff, 2016 and Altavilla et al., 2015).
Challenges for central bank independence in the low-inflation period
The legacy of the great financial crisis of 2008 and the low inflation conditions that
have since been observed bring new challenges for central bank independence. These
challenges fall into two categories. First, the instruments' independence of central banks has
been put into question by external parties. Second, even if the instruments' independence is
not formally challenged, it may be effectively compromised as a result of the changed
conditions. The two kinds of challenges are obviously interconnected. A formally independent
central bank facing effective constraints in the conduct of its policy may find it harder to
deliver on its mandate and may subsequently face calls for restricted independence. On the
other hand, a central bank whose independence is under threat may be constrained in its
policy (instruments) choices. All in all, current circumstances pose challenges for the
successful regime of monetary dominance paradigm established in recent years.
External challenges to the instrument's independence mainly stem from political
pressure. In the US, for example, proposals have been tabled to subject the monetary policy of
the Federal Open Market Committee (FOMC) to unlimited congressional policy audits; adopt
a specific equation in setting monetary policy and require from the FOMC to justify, through
congressional hearings and investigations, deviations from the policy dictated by that
equation; and use the Fed as a source of finance to monetize specific government initiatives
(see Fischer, 2015). In the euro-area, on the other hand, the QE programme has been
challenged both for being too expansive, as well as for being too limited. Similar criticism has
been voiced regarding the effects of monetary policy in the UK.
My own verdict is that the challenge should not be in the very concept of independence,
but rather in the current economic policy mix: loose monetary policy plus tight fiscal policy.
By keeping interest rates in negative territory for too long, the redistribution effects of
monetary policy and the perceived degree of success of meeting the mandated objectives
become more pronounced.
Starting with the former, low interest rates redistribute wealth from savers to borrowers;
and result in higher asset prices. Reduced real returns on savings have caused reactions from
circles representing the savers' constituency, both within and across countries, a point
particularly relevant within the EMU; and as the distribution of asset holdings is highly
uneven among sections of the population, the benefits of QE programmes may also be seen to
be uneven. On the other hand, CBI independence may be questioned as long as recovery in
major economies remains fragile; or is perceived as not achieving equally good performance
across the board of its extended set responsibilities including, for example, financial stability.
The independence of central banks may be scrutinised due to concerns as to whether a
central bank with an extended mandate of objectives can operate transparently and with an
appropriate degree of accountability in the context of a democratic political and economic
system.
All in all, an independent central bank that is subject to democratic accountability needs
broader support from the public. Clearly, with persistent negative rates you are bound sooner
or later to lose major parts of the broad constituency that you need as an independent central
banker.
Central banks have resisted challenges to their independence, pointing to the fact that
political pressure onto monetary policy, mainly stemming from the fact that political cycles
are shorter than the cycles faced by monetary policy design and implementation, introduces
into macro-performance exactly the kind of pressure CBI was initially meant to address. For
example, in the US, despite low inflation, survey-based measures of longer-term inflation
expectations remain in the area of 2% (see Fischer, 2015). In the euro-area, the ECB's
decision to extend its QE programme has been taken in full independence, with a view to
achieving the medium-term price stability objective within an environment of decentralised
national fiscal and structural policies (see Coeuré, 2015). Similar clear statements of intent
have been recently expressed by the Governor of the Bank of England in the wake of
questions raised at high political level regarding the present course of UK monetary policy.
Central banks' opposition to calls for formally restricting their independence does not
ensure that monetary policy may not face effective restrictions in its choice of monetary
policy instruments. This risk mainly comes from the interaction of monetary policy with other
policies, namely fiscal, structural and financial. Separate authorities charged with the conduct
of these policies may be formally independent, they are, however, also interdependent. The
risk raised by such interdependence is that if one independent policy authority does not take
appropriate action to meet its mandated objectives, the remaining independent authorities may
be obliged to over-react in a persistent manner in order to meet their own objectives. To
provide an example, a direct way of identifying such a policy interdependence failure is in the
field of nominal demand: e.g. in the eurozone, nominal demand in Q2/2016 was only 7%
higher than in Q2/2008 (real domestic demand was 1% lower than it had been in the
abovementioned periods), but much lower than the potential increase in its trend rate (roughly
at 24% cumulatively, assuming a trend rate of real growth of 1% and a target inflation rate of
2%). Compare this number (7%) with the one for the US 23% of nominal demand growth
during the same period. In brief, this may result in a regime of "weak dominance" of other
policies over monetary policy, effectively destabilising the regime of monetary dominance
that CBI is meant to establish. Another example of such potential weak dominance relates to
the expansion of the balance-sheets of central banks in the context of QE programmes. This
expansion may increase as a result of imperfections in the response of other policies to
negative economic shocks. Such imperfections might pre-commit future monetary policy to
lower than optimal for business cycle management interest rates, to prevent the central bank
from registering large losses on its balance sheet caused by increased interest rates. This may
have an important second round effect, as a low-interest rate bias in monetary policy could
potentially render public budgets constraints less binding, causing a deficit bias in fiscal
policy, threating price stability as explained by the fiscal theory of the price level.
It follows, therefore, that the ability of central banks to exercise optimally their
instruments independence and deliver their mandated objectives crucially depends on policy
co-ordination between monetary policy and other policies, namely financial, fiscal and
structural (see Coeuré, 2015). The importance of such co-ordination cannot be understated in
the present conditions. The financial crisis of 2008/2009 has left a legacy of debt overhang
and bank undercapitalisation, hindering the ability of banking systems to finance the real
economy. To the extent that these undercapitalisation problems are not resolved satisfactorily,
monetary authorities may need to take extra steps to increase liquidity (such as, for example,
the LTRO programmes), thus creating a regime of financial-policy dominance over monetary
policy. Fiscal policy may also be subject to the same financial dominance: If bank
undercapitalisation problems result into direct or indirect banking support programmes
(through, for example, the establishment of bad banks), fiscal space is reduced; and the ability
of fiscal policy to operate as a shock absorber declines, placing even greater pressure on
monetary policy to operate as such. European Banking Union (EBU), with the Single
Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) at the heart of
its operation, was designed precisely to offer a governance framework to separate fiscal and
banking risks, so that the framework of monetary dominance is preserved in the euro-area,
reverse the process of financial fragmentation observed following the global financial crisis
and the European debt crisis; and restore the smooth operation of the transmission channels of
the single monetary policy.
Similar arguments apply to the field of structural policy. As suggested by the theory of
optimum currency areas, limited flexibility in the goods, services and labour markets, restricts
the ability of the economy to adjust towards its natural output following economic shocks,
thereby increasing the pressure on fiscal and monetary policies to offset to operate as shock
absorbers. This pressure is particularly strong under negative shocks, due to downward
rigidities in prices and wages. Limited flexibility may therefore result into a structural-
dominance regime, resulting into sub-optimal, fiscal and monetary over-reactions in the event
of shocks. In the context of the eurozone in particular, the problem of shock stabilisation takes
an extra dimension, given that second-best fiscal responses may not be available at national
level, due to the existence of rules restricting national fiscal policies, not to mention market
constraints following the increase in government bond yields at the height of the European
debt crisis. This has led to calls to revise fiscal rules, allowing greater fiscal discretion at
national level. These calls have been partially endorsed following the revision of the Stability
and Growth Pact, which compared to its original version now places greater emphasis on the
stock rather than flow of fiscal liabilities; and has shifted the emphasis of the rules'
application from the short- to the medium-term.
Concluding remarks
In closing, it is true that during the Great Moderation period, central bank independence
proved a highly-successful institutional innovation, primarily responsible for delivering the
highly-valued public good of price stability. This policy objective, and the independence of
central bank in its pursuit, should be maintained in the current period of low inflation, posing
multiple challenges for central bank independence.
Having said that, the lessons from the destabilising effect of financial crises cannot be
ignored. Without any doubt, the information set under which central banks operate should be
enhanced to consider risks to financial stability. Whether, however, central banks should be
primarily responsible for ensuring financial stability is less clear - the jury on this question is
still out. Some may call it independence, others may view it as autonomy; some may want to
think of it as a misnomer, others may view it as something deeper in the end which affects a
central bank's operational independence. However, on the balance of existing theory and
empirical evidence, I maintain that an independent central bank focused on price stability,
along with structural adjustments, appropriate and sustainable fiscal policies and an enhanced
technology ensuring macro-prudential stability offer the most promising path for restoring
normal growth conditions and the creation of jobs, which is the ultimate objective.
Independent central banks can exercise optimal policies towards delivering their mandated
objectives only when they are well-coordinated with other policies, including fiscal and
structural ones.
Thank you very much for your attention!

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