For release on delivery
7:00 a.m. EST (9:00 a.m. local time)
November 14, 2024
Central Bank Independence and the Conduct of Monetary Policy
Remarks by
Adriana D. Kugler
Member
Board of Governors of the Federal Reserve System
at the
Albert Hirschman Lecture
2024 Annual Meeting of the Latin American and Caribbean Economic Association and the
Latin American and Caribbean Chapter of the Econometric Society
Montevideo, Uruguay
November 14, 2024
Thank you for your generous introduction, Marcela, and thank you for the
opportunity to be here and speak to you today.1 I believe I am the first central banker
from the U.S. to address this annual meeting, but I know, and am proud to say, that I am
the first who is also Latin American. And, of course, I have been part of the LACEA
Executive Committee and I have presented papers at many LACEA conferences over the
years, so it is a pleasure to be back here among many colleagues.
When the United States suffered very high inflation beginning in 2021, it was a
new and unfamiliar experience for many too young to recall the last time this occurred in
the 1970s and 1980s. Of course, very high inflation is not such a distant memory for
people from Latin America and the Caribbean, and that includes me. Growing up in
Colombia, I vividly recall the daily challenges of trying to plan and live with sustained
double-digit inflation, and I especially remember the pain it imposed on disadvantaged
people.
Gaining control over inflation requires a commitment by society to accept the
tradeoffs and sacrifices often needed, and it also requires deliberate and principled
decision making by central banks.2 Central bankers must both formulate their best
judgment of the correct policies that will achieve a desired level of inflation and follow
through by executing and maintaining those policies. It has been widely recognized-
and is a finding of economic research-that central bank independence is fundamental to
achieving good policy and good economic outcomes. It is not sufficient by itself to
achieve those goals, but, over time, it is almost always necessary.
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Let me start by defining terms. An independent central bank is one that can carry
out monetary policy insulated from pressures arising from other parts of government or
elsewhere. When there is central bank independence, the role of national or jurisdictional
governments is typically one of representing the public in specifying a mandate for the
central bank and holding the central bank accountable by monitoring its performance and
appointing central bank leadership. In this arrangement, the public, through
representative government, specifies the overall objectives that central banks should
pursue.
Some noteworthy examples of central bank mandates include the dual mandate
established by the U.S. Congress that requires the Federal Reserve Board and the Federal
Open Market Committee (FOMC) to promote maximum employment and price stability.
The European Central Bank's primary mandate of price stability is spelled out in a treaty
enacted by the legislatures of its constituent member states. The central bank of Brazil
pursues price stability as its primary objective as well. In the United Kingdom, its
parliament has mandated that the Bank of England pursue monetary and financial
stability.3 Similarly, the objectives of the central banks of Chile and Uruguay are both to
keep inflation low and stable and to foster the stability and efficiency of the financial
system.
Before we discuss why monetary policy independence can benefit the economy,
let me take a step back and discuss the tradeoffs associated with the conduct of monetary
policy. Central banks significantly influence prices, interest rates, employment, and
income in the economy, so it is natural that sometimes there would be differing views on
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their decisions. For instance, monetary policy actions that promote economic activity and
employment growth can put upward pressure on inflation. Conversely, policies to lower
inflation tend to slow economic activity and employment growth. This tradeoff typically
means that returning inflation to a specific target level when inflation has been allowed to
run high may require more restrictive policy and a reduction in demand and higher
unemployment. As I pointed out in a speech last spring at Stanford University, however,
we have seen this tradeoff dissipate over the past couple of years, pointing to the
possibility that we have been now for some time on the steep part of the Phillips curve,
where inflation can come down substantially without a big increase in unemployment.
Yet there is a possibility that this tradeoff may become more prominent as we move
toward the flatter part of the Phillips curve.
The economic literature points out that striking a balance in these tradeoffs can be
difficult for an elected or otherwise representative government for various reasons. One
reason highlighted in the literature is that an elected government may be naturally
focused on the short-term goals of its constituents and may have an incentive to try to
lower the unemployment rate in the short run, with less concern about the longer-term
effects on inflation and growth. The literature has labeled this fundamental problem
"time inconsistency."4 This incentive may generate undesirable economic cycles,
potentially destabilizing prices. And if the public learns over time that the central bank is
responsive to these incentives to increase inflation to boost employment temporarily,
expectations of future inflation would rise, a symptom of a loss of credibility of the
monetary policy authority. Governments also may have an incentive to increase inflation
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to monetize their debts, which become effectively smaller as the purchasing power of
money declines. Also, if elected officials are responsible for monetary policy decisions,
the typical alternation in control of government between different parties may lead to
different preferences in the tradeoff between employment and inflation, destabilizing
prices and the economy in the long term.5 In summary, economic research argues that
demands on government to address concerns in the short term may result in excessively
discretionary monetary policy and do not provide the best incentives for effective
monetary policy that promotes the long-term health of the economy.
A solution devised by governments and explored in economic research is to
delegate monetary policy to an independent entity: the central bank.6 By establishing
policy mandates in laws or treaties, the government voluntarily constrains itself from
suddenly altering policy, and thus it also discourages public pressure to do so. As in
Homer's Odyssey, in which Odysseus asks his crew to tie him to the mast of his ship to
avoid being bewitched by the Sirens' songs, policy mandates help central banks avoid
being swayed by short-term desires to the detriment of longer-term goals.
Now that we have discussed the reasons for delegating the authority to conduct
monetary policy to an independent entity, we are left with the task of describing how
such independence should be designed and implemented in practice. There are two broad
categories of central bank independence. The first of these is goal independence-to
what extent is the central bank free to define its goals? The research literature makes a
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distinction between instrument independence-the prerogative to make monetary policy
decisions, which I will discuss more later-and goal independence.7 In particular, the
Federal Reserve's goals are defined by law, so it is not goal independent. Nevertheless,
in spelling out those goals, the law provides the Federal Reserve with some degree of
independence in defining them in detail.
First, let's talk about the extent to which the law has defined the Federal
Reserve's monetary policy goals. Unlike some other central banks that target inflation,
the FOMC has been handed two coequal goals-maximum employment and price
stability. The Committee is not free to pursue one or the other-it must pursue both.
And these two sides of the mandate are pretty clear. Maximum employment means, in
effect, the lowest unemployment rate that is consistent with stable prices. The law does
not spell out a level of inflation that fulfills the goal of stable prices, but it has
traditionally been viewed as a low and stable inflation rate.
Mandates limit goal independence, but the form of those mandates can allow
some role for the central bank in setting out its goals. The 1977 law defined the Federal
Reserve's dual mandate, allowing the FOMC to work out the details. In 2012, the FOMC
defined price stability as a longer-run annual inflation rate of 2 percent, as measured by
the Commerce Department's estimate of the rate of increase in the personal consumption
expenditures (PCE) deflator. Because maximum employment is unobserved and likely
changes over time, it can be estimated only with considerable uncertainty; thus, the
Committee chose not to define it in numerical terms. But Committee participants
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estimate a related number, the longer-run rate of unemployment, which is published
every three months in the Summary of Economic Projections.
Another aspect of independence is instrument independence, which affords
central banks flexibility in how to use the tools of monetary policy, such as policy interest
rates, to achieve their goals. In the case of the FOMC, instrument independence has
allowed it to adopt new ways to achieve its goals, as the financial system has evolved
over the decades. This has been particularly important when the economy faced
unprecedented challenges, as it did during the 2008 Global Financial Crisis and during
the 2020 pandemic. Because of this flexibility, the Federal Reserve Board and the
FOMC were able to respond promptly and, as it turned out, very effectively.
Across countries and jurisdictions, goal independence and instrument
independence have different dimensions and many variations. In some countries,
including India, Brazil, and South Korea, the targets for inflation rates are jointly decided
by the central bank and the ministry of finance. In contrast, the central banks of Chile,
Colombia, Mexico, and Peru, among others, are given authority to choose their own
inflation objectives.
To understand how governments have come to embrace the independence of
central banks, it is helpful to review how they have evolved from their origins in the 17th
century. Sweden's Riksbank was established by the private sector in 1688 to lend the
government funds, and the Bank of England followed in 1694, with a similar structure
and purpose.8 Other European central banks followed in the 19th century and a wave of
many more in the 20th, including the Federal Reserve. At different times, these central
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banks made the transition from wholly private to wholly public institutions and became
accountable to government, and by the mid-20th century, there was a growing
recognition that independence made for a more practical and, ultimately, more effective
central bank. In the United States, the moment of truth came in 1951. During World
War II, the Federal Reserve had agreed to peg interest rates on Treasury securities in
order to ensure smooth funding of the war effort, and after the war, it continued to peg
the longer-term Treasury rate. In the early 1950s, inflation soared, but Treasury favored
continuing a cap on longer-term interest rates so that debt management costs could
continue to be low during the Korean War. After a series of high-level meetings, the
Federal Reserve and the Treasury reached an agreement in 1951 that freed the Fed from
the obligation to fix interest rates and allowed it to use monetary policy independently to
pursue national economic goals.
Researchers have analyzed the historical experiences of particular central banks,
such as the Federal Reserve, to understand the transition toward central bank
independence and how it affects economic performance.9 In addition, researchers have
also developed large cross-country indexes measuring the level of central bank
independence while capturing multifaceted aspects of this independence based on banks'
legal statutes over long periods.10 The empirical regularity that stands out in many
different studies analyzing these indexes is the rise in central bank independence starting
in the 1980s, with studies analyzing at least 120 countries.11
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Economic research has cited several factors driving this adoption of central bank
independence. In the 1980s and 1990s, emerging economies saw central bank
independence as a way to facilitate access to global trade and financial markets, which
were liberalized during that time.12 Another important factor was the experience of
developing country debt crises during this period, which led to demands by creditor
banks and international lenders for central bank independence.13
To whatever extent these other factors pushed governments toward central bank
independence, a consensus developed that such an arrangement yielded better economic
outcomes. Based on measures of central bank independence, researchers indeed have
found a relationship between independence and lower inflation, especially for advanced
economies.14 While evidence of a negative relationship between independence and
inflation has been a bit more elusive in the case of emerging market and developing
economies (EMDEs), the economic literature does find a relationship between
independence and lower inflation volatility in these countries.15 Among the reasons I
would cite for why it is more difficult to find a relationship between independence and
lower inflation in EMDEs is that legal measures of central bank independence, also called
"de jure independence," may not reflect the relationship between the central bank and the
government that exists in practice-referred to as "de facto independence." In countries
where the rule of law is not as strongly embedded in their institutions, there can be wide
gaps between the formal, legal institutional arrangements and their practical effect.16
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Indeed, alternative measures of independence, such as turnover of central bank
governors, point to de facto measures being negatively associated with inflation,
especially in emerging economies.17 Another possible reason is that emerging economies
may be more exposed to volatile shocks and governmental regime changes, leading to
greater turnover in central bank leadership and clouding the relationship between central
bank independence and inflation.18
The relationship between central bank independence and lower inflation and
inflation volatility is therefore clear. But the connection to faster growth in economic
activity is not. On the one hand, the primary reason for central bank independence in
most countries with a single mandate is to provide price stability, so the lack of
association between monetary policy independence and adverse economic consequences
is not surprising.19 On the other hand, indexes of central bank independence may be
biased. Most indexes of central bank independence tend to penalize the presence of
additional mandates or responsibilities beyond price stability.20 However, a mandate that
excludes full employment does not seem optimal, given that a central banker should
focus on the consequences of its actions on long-term growth and economic activity.
Research has emphasized complementarities between price stability, economic stability,
and financial stability, providing a rationale for these overlapping objectives at many
central banks.21 Also, in practice, although the recent inflation run-up showcased the
commitment of most central banks to fight inflation, it also appears that they have been
willing to provide some accommodation after having gained greater confidence that
inflationary pressures have dissipated. In fact, most central banks have initiated an
easing cycle even with inflation still somewhat above their respective targets and
regardless of the presence or not of an employment goal in their mandates.
So if central bank independence does improve inflation outcomes, one question is
how it accomplishes this. Let me return to an issue I mentioned earlier: credibility. If
the central bank is credible about its longer-run inflation target, it would be a natural
outcome that long-run inflation expectations will tend to be closer to the target than when
that credibility is lacking. And a central bank will be more credible if it takes actions that
lead the public to be confident that the central bank is actively pursuing its stated goal.
It is possible to formalize the channel through which a central bank chooses a
long-run inflation target and the public slowly learns about its commitment to achieving
it, thus gradually anchoring long-run expectations.22 The public observes inflation and
economic activity outcomes as well as the central bank actions (say, changes in the
federal funds rate), and it updates its long-run inflation expectations, which, in this
model, coincide with its perception of the long-run target. For instance, a nominal
interest rate that is higher than expected, given observed inflation and economic activity
and the public's long-run inflation expectations, leads to an updated-lower-value of
the perceived inflation target.
If the central bank's policy actions are consistent with its long-run inflation goal,
the public's long-run expectations will gradually settle at the central bank's long-run
goal: This dynamic will anchor inflation expectations to the long-run target. The stock
of credibility of a central bank will be reflected in long-run inflation expectations moving
in a relatively narrow range close to the stated inflation goal. Conversely, inconsistent
actions will imply that agents will update their long-run expectations higher or lower,
depending on the direction of surprises in central bank actions, causing de-anchoring of
expectations. Despite a very large inflation shock starting in 2021, available measures of
long-run inflation expectations, such as those in the Survey of Professional Forecasters or
the Livingston Survey, increased just a bit compared with the inflation run-up and
quickly descended in 2023. That can be taken as a sign of anchoring and sufficient
central bank credibility through the lens of the model just described. And, to the extent
that long-run inflation expectations matter to the dynamics of actual inflation, such as in
some Phillips curve models, anchoring of inflation expectations is one of the key
elements leading to stable inflation.23
The model also offers an interpretation of and a contrast to the behavior of
inflation and inflation expectations during the Great Inflation of the 1970s and in the
post-pandemic period. As inflation rose in the 1970s and monetary policy actions failed
to rein it in, the Federal Reserve lost credibility, and longer-term expectations of future
inflation rose toward the end of the decade. The Federal Reserve struggled for years to
rebuild that credibility, resulting in high and volatile inflation. Conversely, in the recent
episode, inflation has traveled a long way from its peak, with no deterioration in
economic activity and comparatively limited movement in long-run inflation
expectations.
Credibility is enhanced by transparency and accountability, and I will conclude
with a discussion of how these principles are carried out by the Federal Reserve. The
Federal Reserve seeks to explain as clearly as possible what it is trying to do in carrying
out its dual-mandate objectives and how it is trying to do it. Such transparency and
accountability are necessary under our democratic system but are perhaps especially
important for the Federal Reserve, which has been assigned such an important role in
promoting a healthy economy. In addition to conferring legitimacy for decisions,
transparency makes monetary policy more effective, as the public better understands our
monetary policy reaction function, which informs the public on how our decisions are
shaped by economic conditions. Monetary policy works in part by trying to influence the
public's view of future economic conditions, so it is crucial that these intentions are
clearly communicated. The Federal Reserve promotes transparency by issuing a
postmeeting statement explaining its decision and then following up with more detailed
minutes three weeks later. Every three months, FOMC participants' projections for
inflation, unemployment, economic activity, and the likely path of monetary policy are
published in the Summary of Economic Projections. The Chair conducts press
conferences after each FOMC meeting, and both the Chair and FOMC participants
further explain their reasoning on policy in speeches, news interviews, and other public
appearances. The Chair testifies to Congress on monetary policy twice a year,
responding to questions from lawmakers. Transcripts of FOMC meetings are published
after five years. More recently, the Fed has adopted the practice of periodically
reviewing its monetary policy strategy, tools, and communication practices, including
holding public Fed Listens sessions around the country to get public input.
Transparency is likewise seen in other economies as fundamental to monetary
policy independence, which has increasingly been recognized for delivering better policy
decisions that are more focused on the longer-term health of an economy. Research
continues to add to our understanding of the extent of these better outcomes in different
economies and also how independence works in different institutional arrangements. The
goal, of course, is more stable economies that deliver broadly rising living standards-in
Latin America, the Caribbean, and around the world.
Let me now turn to the current economic outlook in the United States and how
our monetary policy independence has permitted us to get where we are now. The United
States has seen considerable disinflation while experiencing a cooling but still resilient
labor market. Numbers just released this week show headline and core PCE inflation
have fallen substantially from 7.1 percent to an estimated 2.3 percent and from 5.6
percent to an estimated 2.8 percent, respectively. While wage moderation and anchored
inflation expectations may allow us to continue making progress on inflation, stubborn
housing inflation and high inflation in certain goods and services categories may stall
progress in reaching our target. At the same time, labor markets have rebalanced, given
greater labor supply from immigration and prime-age workers and lower demand from
restrictive monetary policy. Thus, although the labor market experienced an extended
period of low unemployment and job creation these past several years and strong real
wage growth, the labor market has cooled. This combination of a continued but slowing
trend in disinflation and cooling labor markets means that we need to continue paying
attention to both sides of our mandate. If any risks arise that stall progress or reaccelerate
inflation, it would be appropriate to pause our policy rate cuts. But if the labor market
slows down suddenly, it would be appropriate to continue to gradually reduce the policy
rate.
Thank you again for inviting me to address you today. I would be glad to spend
some time on further discussion of my presentation and to respond to your other
questions.
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