Stanley Fischer: Central bank independence
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the 2015 Herbert Stein Memorial Lecture National Economists Club, Washington
DC, 4 November 2015.
* * *
The views expressed here are my own and not necessarily those of others at the Board, on the Federal Open
Market Committee, or in the Federal Reserve System. I am grateful to Kurt Lewis, Ellen Meade, and Jonathan
Rose for their help in preparing this speech.
It is a pleasure to speak to you tonight and an honor to deliver the 2015 Herbert Stein
Memorial Lecture. My subject tonight is central bank independence. But before turning to that
topic, I would like to explain why this is a special occasion for me.
My first real-world involvement in economic policy began late in 1983, when I was invited by
Secretary of State George Shultz to join a small team to advise him on the stabilization of the
Israeli economy, then suffering from triple-digit inflation and other ills. Herb Stein, formerly
chairman of the Council of Economic Advisers under Richard Nixon and Gerald Ford, was
also on that team. Herb was 67, wise, witty, and experienced, and I was 40 years old, with a
lot still to learn. By mid-1984, the advisory team consisted of only Herb and me.
The experience of working for George Shultz, in partnership with Herb, was not only
wonderful, but it also changed my life, for after that I had the policy bug. I believe our team
made a real contribution to the success of the Israeli stabilization program that began in
mid1985 and which is now recognized as a critical turning point in Israel's economic history. But
tonight is not the occasion to retell that story.
Rather, let me tell you a bit about Herb via what should be called Herbisms. The most
famous one is "If something cannot go on forever, it will stop," which comes in very handy
when trying to persuade someone to stop implementing policies that are driving their
economy straight into a stone wall. A second Herbism is extremely useful when discussing
economic growth or interest rates: "The difference between a growth rate of 1 percent and a
growth rate of 2 percent is 100 percent." I have many more but will stop at three. While we
were having dinner in a Washington, D.C. restaurant sometime in 1984, Herb asked me what
was happening in the Israeli economy. I replied with an excellent exposition of monetary and
fiscal policies, the accelerating inflation rate, all of the mistakes that were being made, who
was doing what to whom, and more. If I had been a graduate student, I would certainly have
received an A. Herb's response was not to congratulate me on the excellence of my analysis,
but to ask gently, "Yes, but what do we want them to do?" That is a question one should
always remember to ask when trying to advise a policymaker.
In brief, I learned an enormous amount from working with Herb and soon came to admire him
as a man of strong but softly stated principles and immense decency, with whom it was a
pleasure and privilege to be able to work and to talk - and, of course, to joke, for he had a
great sense of humor. If you want to know more about him, go to Google, look up Herbert
Stein, and find the speech that his son Ben delivered at the first Herbert Stein Memorial
Lecture, in 2012. And I'm very happy indeed that Herb and Mildred's two children, Rachel
and Ben, are here tonight.
Central bank independence over the past 20 years
The modern academic literature on central bank independence developed largely in the late
1980s and the first half of the 1990s. The world of central banking was very different then - a
fact brought home by recalling that, in the early 1990s, the interest rate in the United
Kingdom was still set by the Treasury and not the Bank of England. At its tercentenary
celebration in 1994, the Bank of England organized a symposium on central banking,
motivated in part by its desire for independence from the Treasury and the modernization of
its legal structure.
I gave a speech on monetary policy independence and modern central banking at the
tercentenary celebration, in which I made the case for central bank independence and
concluded with the sentence "On her 300th birthday, it is time to allow the Old Lady to take
on the responsibilities of independence."1 At that time, visitors to Britain who raised the issue
of independence for the Bank of England were typically treated to a lecture on why that was
not possible in the British political system. Nonetheless, independence was granted to the
Bank of England by a newly elected Labour government in 1997, and subsequent
researchers have linked this independence to declines in both longer-term inflation risk
premiums and inflation expectations.2
The literature I discussed in my 1994 speech was developed with an emphasis - based on
post-World War II experience - on the problem of preventing high inflation. But we are no
longer in that era. The inflation problem with which most of the leading economies are
dealing is inflation that is too low, not too high. Further, now that we have had time to
understand better the damage that the global financial crisis has wreaked on the world
economy, and after much research on the effect of major financial crises on growth and on
the dynamics of business cycles, we are focused to a much greater extent than in the past
on the importance of financial stability.
I would like to use our time tonight to reflect on how the analysis of central bank
independence of 20 years ago should be updated to reflect the different economic
environment in which we are now living. I shall argue that, although high inflation is not the
immediate concern that it was in the 1980s and 1990s, monetary policy independence
remains of the highest importance, and that it is important that we preserve monetary policy
independence to help foster desirable macroeconomic outcomes and financial stability.
The case for monetary policy independence
By 1994, both theory and evidence suggested that more independent central banks deliver
better outcomes, particularly lower and more stable inflation. The theoretical case for
monetary policy independence focused on countering inflationary biases that were likely to
exert themselves in the absence of an independent central bank. Such a bias could result
from political pressure to boost output in the short run - for example, before an election - or
to use a central bank's power to issue money as a means to finance government spending.
Even in the absence of political interference, inflationary bias can result from the problem of
dynamic inconsistency if central banks cannot credibly commit to keeping inflation low.3
On the empirical side, many scholars have studied whether monetary policy independence
fosters low and stable inflation in practice. Summarizing roughly 25 years of research in his
2008 paper, Alex Cukierman observed that "the evidence is consistent with the conclusion
that inflation and actual [independence] are negatively related in both developed and
developing countries."4 Further, monetary policy independence does not appear to be
associated with adverse economic consequences. In particular, to the extent that
independence of the central bank helps restrain inflation, it does not appear to result in
significantly more volatile output, as some theoretical models had predicted.5 Cukierman
goes on to note, however, that the causality from independence to lower inflation is not clear,
and several studies over the past 10 to 15 years have found conflicting results on that front.6
Let me touch on four issues that are now an essential part of the understanding of central
bank independence, but that were less prominent in the 1990s. First, there is a distinction
between the terms monetary policy independence and central bank independence. In the
literature that developed before the global financial crisis, central bank independence
referred to independence from political influences in the setting of monetary policy. But many
central banks have roles outside monetary policy - in particular, bank regulation and
supervision. These roles are in certain cases granted their own level of independence, a
subject to which I shall return later in the lecture.
Second, there is a useful distinction between goal independence and instrument
independence.7 A central bank's mission - its purposes and goals - are set out in its
founding legislation and subsequent refinements. The purposes may be general, such as
preserving the value of the currency, maintaining the stability of the financial system, and, in
some countries, promoting economic growth or employment. These purposes have typically
to be translated into operational goals - for instance, maintaining an inflation rate of
2 percent. The question of goal independence is whether the central bank itself establishes
the operational goals or whether some other official body does so. Examples of such bodies
are the finance ministry or the cabinet. If the central bank sets the operational goals, it has
goal independence; if those operational goals are defined by some other body, the central
bank does not have goal independence.
The academic literature was developed during the early 1990s when the Federal Reserve
had already been given its statutory mandate of maximum employment and price stability.
After careful deliberation, the Federal Open Market Committee (FOMC) clarified that inflation
of 2 percent is most consistent with the goal of price stability.
The powers and instruments the central bank has at its command are also generally
specified in legislation. If the central bank has control over the policy instruments it has been
assigned, it has instrument independence. Virtually every central bank has the authority to
engage in asset market transactions, with the goal of setting a specific - typically short-term
- interest rate or, closely related, of controlling the money supply. There have been
proposals - for instance, by Milton Friedman - that the central bank be required to cause the
money supply to grow at a constant rate, 4 percent. Such a central bank would have neither
instrument nor goal independence.
Third, the power to set the short-term interest rate or the money supply is a formidable one.
Well exercised, that power can support the stability of both prices and output; poorly
exercised, it can create economic havoc. Any institution to which such responsibility has
been delegated must be held accountable for carrying out its mission effectively and
efficiently. In almost all countries, the central bank's accountability is enforced by requiring
regular reporting on monetary policy actions and outcomes to the legislature, to the executive
branch, and to the public. The formal centerpiece of the required reporting is generally
exercised by the regular publication and presentation to the legislature of an inflation report
or monetary policy report, followed by public hearings on the report and related matters.
Accountability can be further enhanced by increasing the transparency of central banks
about their operations.
Accountability of the central bank helps deal with the potential conflict between the benefits
of shielding the central bank from political pressures and the fact that unelected officials -
albeit officials who are commonly nominated by the government and, in many cases,
confirmed by the legislative branch - are determining policies critical to the country's
economy.
Fourth, there is an argument in the profession about the difficulties of presenting a central
bank with more than one policy goal. The argument is often put as "You need as many
instruments of policy as you have policy goals," a result often attributed to Jan Tinbergen,
cowinner of the first Nobel Prize in economics.8 Tinbergen's result is correct if the targets have
to be achieved exactly, but it is not correct if there are tradeoffs among the goals of policy,
and the central bank utility or loss function includes the costs of missing each of the targets
and the interactions among them.9
Based on the Tinbergen result, central banks whose mandated goals are narrow, such as
having only an inflation target, are often considered to have more independence than central
banks with additional targets or with multifaceted objectives. In practice, I doubt that any
central bank targets inflation to the exclusion of all other outcomes. For example, the
Bundesbank was generally thought to have a very strict focus on inflation in the years in
which it had an independent monetary policy before the founding of the European Central
Bank. But researchers who have studied the Bundesbank's policies of that period have
concluded that it likely responded to deviations from target of both expected inflation and
output growth.10 I do not regard the Fed's dual mandate, which gives it both an inflation and
an employment goal, as causing significant difficulties for Fed decisionmakers, and note that
if the Fed had only an inflation target and found itself in the situation we find ourselves today,
it would face precisely the same difficulty we currently face - how to get the inflation rate up
to meet the inflation target.
The Fed today
The Federal Reserve System's current mandate of maximum employment, stable prices, and
moderate long-term interest rates was established by an amendment to the Federal Reserve
Act in 1977. The Congress, in effect, recognized the principle of instrument independence by
requiring that the Federal Reserve Board report semiannually directly to the Congress about
the Board's and the FOMC's plans to meet these objectives and by exempting monetary
policy from Government Accountability Office (GAO) review as part of the Full Employment
and Balanced Growth Act of 1978.
By passing these two pieces of legislation, the Congress put in place a mechanism for
holding the Fed accountable for meeting its statutory mandate. A key venue for reviewing the
Fed's approach to pursuing its mandated goals remains the semiannual testimony of the
Chair, along with the associated Monetary Policy Report. In general, the provision of such an
accountability structure is important, since, as previously noted, accountability to elected
officials and the public is an essential complement to central bank independence.11
The Federal Reserve's accountability structure has been largely stable since the 1970s
reforms. At the same time, the Federal Reserve has greatly augmented its public
communications about its economic outlook and its policy strategy. Over the past 20 years,
this augmentation includes the release, beginning in 1994, of postmeeting statements
explaining policy decisions.12 Other changes include the inclusion of roll call votes in the
postmeeting statements in 2002; the release of the FOMC minutes three weeks after the
meeting rather than following the subsequent meeting, beginning in 2005; the introduction of
the Summary of Economic Projections in 2007 and the inclusion in 2012 of the "dot plot"
showing FOMC participants' federal funds rate projections; the Chair's quarterly postmeeting
press conferences in 2011; and the issuance in 2012 of the FOMC's Statement on
LongerRun Goals and Monetary Policy Strategy, which is reaffirmed every January.13
This increased transparency has been a key complement to the Fed's independence and
accountability by regularly demonstrating that the Fed has been appropriately pursuing its
mandated goals. Transparency can also make monetary policy more effective by helping to
guide the public's expectations and clarify the Committee's policy intentions.14
The Fed, like other central banks, does appropriately retain some matters for private
discussions. These discussions often contain market-sensitive information and may, by
necessity, involve frank assessments of market- or even firm-specific conditions as well as
outside-the-box ideas needed to deal with evolving economic situations. These exceptions
reflect the view that transparency should preserve the ability of policymakers to think out of
the box and should not inhibit free give-and-take and the testing of ideas that is essential to
reaching good decisions. Transcripts of the FOMC's meetings are made available with a
fiveyear lag, allowing researchers to study the closed-door discussions after an appropriate time
has elapsed.
Central bank independence and new challenges
Low inflation
The basic governance structure set up in the late 1970s was envisioned as a means to
monitor and encourage the Federal Reserve to pursue its mandates, and an aggressive and
successful campaign to bring down inflation followed. Indeed, the high inflation of the 1970s
and early 1980s was one of the primary motivations for the broadening and deepening of
monetary policy independence worldwide.
Today consumer price inflation remains below the FOMC's objective of 2 percent. According
to the personal consumption expenditures index, the 12-month change in core prices (prices
excluding the food and energy categories) has been around 1-1/4 to 1-1/2 percent since the
12
Prior to 1999, the FOMC released statements only after meetings at which the federal funds rate was
changed. Over time, the statements released by the FOMC have become more informative about the
Committee's views of the economy and policy.
13
There are a number of additional transparency improvements that are less directly related to monetary policy
communication, including detailed reports on liquidity facility and lending programs during the financial crisis,
which can be found on the Board's website at www.federalreserve.gov/monetarypolicy/bst_reports.htm. In
addition, a full list of securities held in the System Open Market Account portfolio is available on the Federal
Reserve Bank of New York's website at www.newyorkfed.org/markets/soma/sysopen_accholdings.html.
14
Given the benefits of transparency, central banks around the world have also greatly augmented their public
communications over the past 20 years. Recent papers measuring transparency across central banks include
Crowe and Meade (2008) and Dincer and Eichengreen (2014). Dincer and Eichengreen (2014) conclude that
almost all of the central banks around the world had greater transparency in 2010 than they did in 1998. See
for example Figure 1 in that paper. These measures of transparency cover a variety of factors, including the
openness about policy objectives and economic data, disclosures about the procedures used in deliberations,
the speed of such disclosures, and transparency about the operational aspects of meeting targets.
beginning of 2013. At the September 2015 FOMC meeting, participants saw inflation as very
low this year but expected it to pick up notably next year and rise further in 2017.15
Although the presence of low inflation makes the traditional inflationary bias less of an
immediate concern, actions that would compromise monetary policy independence would still
be dangerous. The anchoring of inflation expectations has been a hard-fought product of the
disinflation of the 1980s and subsequent Federal Reserve policy. Today, even with low
inflation, the balance of evidence suggests that survey-based measures of longer-term
inflation expectations have likely remained fairly steady and consistent with our objective.
The anchoring of these expectations is due in great part, I suspect, to the continued
credibility of the Fed's independence from political interference, along with the adoption of
the explicit inflation target of 2 percent.
To put this point clearly, the concern over the effects of political interference in monetary
policy remains as valid in practice when inflation is too low as when inflation is too high. That
is primarily because political horizons are typically shorter than those that need to be taken
into account in making monetary policy decisions.
Recently, there have been proposals to restrict monetary policy independence. One
proposal, labeled "Audit the Fed," would subject the Federal Reserve's conduct of monetary
policy to unlimited congressional policy audits.16 (Financial audits are already conducted
regularly.)17
Another proposal would require the FOMC to adopt and follow a specific equation in setting
monetary policy and to face immediate congressional hearings and investigation by the GAO
whenever the FOMC deviates from the policy dictated by that equation.18 In the terminology I
have used in this speech, these proposals could accurately be described more as restrictions
on the Federal Reserve's instrument independence than as measures that would increase
transparency or accountability. They would thus represent a departure from the modern
governance structure that has come to characterize the Fed and leading central banks
around the world. Since the Federal Reserve is already very transparent about its monetary
policy decisions, review by the GAO would not meaningfully augment communications with
the public but would instead reflect an effort by the Congress to influence the Fed's policy
decisions.
We should recognize that if a GAO review and, likely, a congressional hearing were held
every time a monetary policy decision deviated from a simple equation, as has been
proposed, the Fed would be subjected to the very sort of political pressure from which
experience suggests central banks should be independent. Instead, a modern governance
framework calls for the political system to give the central bank a mandate along with the
operational freedom to pursue that mandate, supported by transparency and accountability.19
In addition, using a central bank as a source of revenue to cover the cost of a fiscal program
is dangerous to its independence. For example, recently some have proposed that the Fed
be used to provide revenue to fund specific government initiatives, which amounts to quasi-
fiscal policy, with manifold implications for central bank independence as well as for the
quality of fiscal policy decisions.20
The Great Recession and the use of unconventional central bank instruments
The basic delegated-authority governance framework I have described - mandated goals,
instrument independence, and accountability - has allowed the Federal Reserve to respond
to dramatic changes in the economic environment over the past 20 years. In particular,
during the Great Recession, instrument independence afforded the FOMC the flexibility
needed to develop new tools that could address the large and extraordinary challenges it
faced in pursuing its dual mandate. The legislative proposals just discussed appear to be
motivated by the belief that the Fed's response during the crisis was somehow ineffective or
inappropriate. In fact, the Fed's response was a carefully considered exercise of instrument
independence that was effective, appropriate, and necessary in light of the congressional
mandate to which it is held accountable. Indeed, without those operations, the U.S. economy
would have suffered a significantly deeper and longer recession than the very substantial
recession we did suffer.
Financial stability
The research on monetary policy independence at the end of the 20th century was
conducted on the assumption that the central bank was focused on its direct macroeconomic
mandates such as inflation and employment. After the global financial crisis, we cannot
ignore the fact that central banks are typically tasked with multiple responsibilities, often
among them, preserving or contributing to financial stability.
These responsibilities do not represent a new mandate - they were the impetus behind the
1913 legislation setting up the Federal Reserve System and, in a somewhat subordinate role,
behind the legislation setting up both the independent Bank of England and the European
Central Bank as well as many other central banks whose legal framework has changed in the
past two decades.21 But these responsibilities have received far more emphasis following the
financial crisis. As has long been known, a central bank must take into account risks to
financial stability if it is to help achieve good macroeconomic performance.22
Could central bank involvement in dealing with potential financial instability present a
challenge to central bank independence? In answering this question, we need to consider an
important difference between the use of traditional monetary policy and the use of
macroprudential policies. Macroprudential policies are typically aimed at a specific sector.
Often the housing sector is disproportionately involved in financial crises.
In the face of an incipient bubble growing in the housing sector at a time when inflation and
unemployment are at their target levels, the first instinct of regulators and others - the central
bank among them - is to turn to macroprudential instruments, such as constraints on the
loan-to-value ratio or the debt-service-to-income ratio of borrowers. However, doing so would
affect particular sectors of the population. This difficulty can, to some extent, be dealt with by
tailoring the macroprudential measures in ways that soften their effect on groups of particular
concern.23 Nonetheless, the housing issue is often politically important, and it could be
argued that the political authorities should have some representation in discussing measures
taken to deal with it.
This representation can be done as in the British case by having a separate committee to
make financial stability decisions, the Financial Policy Committee (FPC), located in the Bank
of England, whose membership is different from that of the Monetary Policy Committee and
on which also sits a nonvoting member from the U.K. Treasury.24 In the U.S. case, the
Financial Stability Oversight Council is a coordinating committee, with all of the principal
regulators as members and the Secretary of the Treasury as chairman. Because the member
regulatory agencies are independent, coordination among them - the function of the FSOC -
is critical to the financial regulatory system's success in addressing risks to financial stability.
There are many other models for the governance of the responsibility for financial stability.
For instance, in Australia, there is a single integrated prudential regulator, the Australian
Prudential Regulation Authority, as well as the Council of Financial Regulators, whose chair
is the governor of the Reserve Bank of Australia and whose members are drawn from the
central bank, the prudential authority, the Australian Securities and Investments Commission,
and the Treasury. These various approaches each have their own merits, but the ultimate
stress test for any particular institutional structure will, of course, come as these new
governance structures face the challenges of dealing with financial stress and potential
financial crises.
The structure of the FPC ensures that the Bank of England is nearly fully independent with
regard to financial stability.25 The Fed does not have that independence, even though it has
been assigned the responsibility of helping to ensure financial stability.
I have heard foreign central bankers argue, "You can't be independent in one function
(monetary policy) and not independent in another (financial stability), without the
nonindependence with respect to financial stability seeping over to weaken the
independence of monetary policy." I do not believe this is correct - as proof, I think each of
us feels and is more independent in some of the decisions we make about our lives than in
others. Thus, I think the Fed retains its monetary policy independence despite its
nonindependence with respect to financial stability policy.
No doubt economists will long debate the appropriate institutional structure for financial
stability authority. Because financial markets and political institutions differ widely across
economies and because historical accident affects the current situation in each, it seems
unlikely that any single set of arrangements will be optimal in all cases.26 In any event, as
time and future potential crises go by - and may they be few and far between - there will be
23
The use of the federal funds rate also affects particular sectors more than others-but that effect is softened
by being spread over the entire economy.
24
A few of the members - namely, the governor and deputy governors of the Bank of England - are on both the
Monetary Policy Committee and the FPC, but the remaining members do not overlap. The FPC members are
the governor, three of the deputy governors, the chief executive of the Financial Conduct Authority, the bank's
executive director for financial stability strategy and risk, four external members appointed by the chancellor,
and a nonvoting representative of the Treasury. The current membership of the FPC is available on the Bank
of England's website at www.bankofengland.co.uk/about/Pages/people/fpc.aspx .
25
The macroprudential tools that the FPC may use were granted to it by specific acts of the U.K. Parliament. In
addition, each year, the chancellor remits a letter to the FPC on issues that are of particular relevance to the
government.
26
This is an instance of a general point made by Avinash Dixit (1996).
far more experience on which to base the choice of regulatory system, and changes will quite
likely be made.27
Finally, as I mentioned at the Federal Reserve Bank of Boston last month, as a result of the
currently limited nature of the macroprudential toolkit, there could be times when adjustments
in monetary policy itself should be discussed as a means to curb emerging risks to financial
stability. Alternatively, financial stability considerations can sometimes point to the need for
accommodative monetary policy. For example, the accommodative U.S. monetary policy
since 2008 has helped repair the balance sheets of households, nonfinancial firms, and the
financial sector. The challenge to monetary policy independence then derives from the use of
a single tool to achieve multiple outcomes across different time horizons. I do not regard this
challenge as a serious constraint on monetary policy independence, but rather as an
inherent aspect of the fact that monetary policy works in the first instance through financial
markets and financial institutions.
The multifaceted nature of macroprudential policy and its interactions with the governance of
monetary policy have important consequences that are not yet fully understood. The
interaction between financial stability and monetary policy, its implications for central bank
independence, and the resulting effects on macroeconomic outcomes deserve extensive
study that is already well under way but probably still in its infancy.
Conclusion
The economic environment has changed considerably in the quarter-century since
economists began the careful study of the theory and evidence on the potential benefits of
monetary policy independence. Over that time, central bankers have had to make use of
their tools - some of them not used previously - to meet unprecedented challenges. Without
the independence to pursue their mandates, this work would have been impossible. But
following the global financial crisis, we are living in a different world, one in which issues of
financial stability have moved out of the shadows and into the center of our concerns. The
resulting challenges are only beginning to be understood - and they need to be understood
and taken seriously if we are to reduce the probability of future financial crises.
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