Laurence H Meyer: The politics of monetary policy
- balancing independence and accountability
Remarks by Laurence H Meyer, a member of the Board of Governors of the US Federal Reserve
System, at the University of Wisconsin, LaCrosse, Wisconsin on 24 October 2000.
* * *
It is widely believed, at least among central bankers, that "independence" is a prerequisite for
achieving the goals that traditionally have been assigned to central banks - specifically for achieving
price stability. "Independence" does not mean literally independence from government, because
central banks here and abroad are almost always part of government. The relationship of central banks
to the rest of government is, in practice, therefore much more complex than the term "independence"
might suggest.
The motivation for granting independence to central banks is to insulate the conduct of monetary
policy from political interference, especially interference motivated by the pressures of elections to
deliver short-term gains irrespective of longer-term costs. The intent of this insulation is not to free the
central bank to pursue whatever policy it prefers - indeed every country specifies the goals of policy to
some degree - but to provide a credible commitment of the government, through its central bank, to
achieve those goals, especially price stability.
Even a limited degree of independence, taken literally, could be viewed as inconsistent with
democratic ideals and, in addition, might leave the central bank without appropriate incentives to carry
out its responsibilities. Therefore, independence has to be balanced with accountability
accountability of the central bank to the public and, specifically, to their elected representatives.
It is important to appreciate, however, that steps to encourage accountability also offer opportunities
for political pressure. The history of the Federal Reserve's relationship to the rest of government is
one marked by efforts by the rest of government both to foster central bank independence and to exert
political pressure on monetary policy.
The purpose of this paper is to clarify the relationship of central banks within government, to explain
the nature, degree of, and rationale for the independence afforded to many central banks - with a
special focus on the role of the Federal Reserve within the US government - and to discuss the
balancing of independence and accountability in principle and in practice.
Independence
The dictionary defines independence as being free from the influence, guidance, or control of another
or others. As applied to central banks, that translates into being free from the influence, guidance or
control of the rest of government, meaning both the executive and legislative branches in the United
States.
It is useful to distinguish two types of independence for central banks: goal independence and
instrument independence. If a central bank is free to set the final objectives for monetary policy, it has
goal independence. If a central bank is free to choose the settings for its instruments in order to pursue
its ultimate objectives, it has instrument independence.
Most central banks have specific legislative mandates and therefore do not have goal independence.
Thus the "independence" of "independent" central banks is instrument independence under which the
central bank has authority to choose settings for its instruments in order to pursue the objectives
mandated by the legislature, without seeking permission from, or being overturned by, either the
executive or the legislature. However, countries vary considerably in the specificity of the mandated
goals and hence in the degree of discretion of central banks in the conduct of monetary policy.
The need for independence
Central bank independence is designed to insulate the central bank from the short-term and often
myopic political pressures associated with the electoral cycle. Elected officials have incentives to
deliver benefits before the next election even if the associated costs might make them undesirable from
a longer-term perspective. This phenomenon has been called the political business cycle in which
preelection stimulus leads to higher inflation followed by monetary restraint after the election.
On the other hand, it appears that elected officials in many countries apparently understood the
incentives under which they operate and have structured charters for their central banks that, in effect,
tie their own hands - that is, limit political interference with monetary policy to enhance the prospects
of achieving and maintaining price stability. Nevertheless, the urge to exert political pressure - to
support the objectives of the Administration as well as those of the Congress, to take the US case, and
other times to support the re-election of the President or of congressional incumbents - sometimes
becomes irresistible. At such times, the tradition of independence at the Fed, the leadership of its
Chairman, the influence of long terms for governors, and the presence of Reserve Bank presidents on
the Federal Open Market Committee (FOMC) become especially important.
In addition, budget priorities and monetary policy objectives can be in conflict. The executive branch
generally wants to keep the cost of servicing its debt low, and this preference might be at odds with the
need for monetary policy to vary interest rates to maintain price stability. This tension has been
present during both World Wars and for several years following World War II.
Finally, especially in countries where debt markets are not well developed, central banks might be
called upon to finance budget deficits by printing money, again interfering with maintaining price
stability. The Federal Reserve, for example, was asked to directly underwrite government debt during
World War I, but a statutory prohibition on directly purchasing government debt was later added to the
Federal Reserve Act.
Some have worried that even an independent central bank could succumb to the temptation to
stimulate the economy today at the expense of higher inflation in the future. This is referred to as the
problem of time inconsistency. That is, the central bank has an incentive to commit itself to price
stability and then to renege on this promise in order to gain employment in the short run with
relatively little initial sacrifice in the form of higher inflation. In the long run inflation would rise and
the central bank would either have to tolerate the higher rate of inflation or push output below
potential for a while to restore price stability. Once the public understood this process, moreover, it
would expect higher inflation, so that, in the longer run, the result could be higher inflation without
any short-run gain in output.
Several solutions to the time inconsistency problem have been offered. First, the rest of government
could impose a rule on the central bank, restricting its ability to play the game described above. The
rule would ensure a credible commitment to price stability, thereby anchoring the public's
expectations and removing the inflationary bias that otherwise might result. Second, the government
could appoint conservative central bankers - central bankers with a greater commitment to price
stability than the public - and thereby offset the inflationary bias that would otherwise arise. Third,
central bankers could be forced to operate under performance or incentive contracts, whereby they
could be penalised for failure to maintain price stability. The Governor of the Bank of New Zealand
operates under such a performance contract; he can be removed from office for failure to achieve his
inflation target.
I have never found the literature on time inconsistency particularly relevant to central banks. Surely
central banks realise they are facing a repeated game, not a one-time game. They will therefore be
reluctant to undermine their credibility over the longer run by pretending to pursue price stability
while stimulating the economy for short-run gain. Long terms and other institutional ways of
insulating central banks from short-term political pressures allow central bankers to take this longer
view and make them less likely to follow time-inconsistent policies. Still, the problem highlighted in
the time inconsistency literature may reinforce the case for both a price stability legislative mandate
and instrument independence for the central bank.
Independence also is likely to reinforce the credibility of a central bank's commitment to price
stability. This enhanced credibility may then yield additional benefits. First, it could allow the central
bank to reduce the cost of lowering inflation. It is generally agreed that to lower inflation monetary
policy must reduce output for a while, relative to potential, by reducing aggregate demand. The
resulting loss of output during the transition to lower inflation is a measure of the cost of reducing
inflation. The more quickly inflation expectations fall, the more rapidly will inflation itself decline,
and the lower will be the cost of reducing inflation.
A credible central bank could also be more effective in conducting stabilisation policy. If aggregate
demand were to slow, a stimulative monetary policy move would be less likely to undermine
confidence in the central bank's pursuit of price stability when the central bank is independent (and
has a price stability mandate). In addition, if inflation moved upward, inflation expectations would be
less likely to follow immediately, making it easier for the central bank to contain inflation.
Evidence on the benefits of independence
An extensive literature examines the relationship between the independence of the central bank and
economic performance. The empirical studies generally find an inverse relationship between measures
of central bank independence and both average inflation and variability of inflation, at least for
developed economies. These are only correlations, however, and thus do not prove causation. The
inverse relationship could also reflect the fact that countries with less aversion to inflation might be
less likely to have independent central banks. In addition, there is no consistent evidence of a
relationship between central bank independence and real economic activity nor consistent evidence
that central bank independence lowers the cost of reducing inflation or increases the effectiveness of
stabilisation policy. On balance, the evidence on the benefits of central bank independence is strong
enough to satisfy those who find the theoretical arguments persuasive, although its is not strong
enough to convince skeptics.
The history and evolution of central bank independence
A century ago there were only 18 central banks, 16 in Europe, plus Japan and Indonesia. Today there
are 172 central banks and over recent years the number of central banks that claim some degree of
independence within government has steadily increased. More central banks have become independent
in the 1990s than in any other decade since World War II.
Changes in Britain, Japan and continental Europe made 1998 a banner year in the history of central
bank independence. The Bank of England, one of the oldest central banks in the world, was founded
by an act of Parliament in 1694. It was involved in commercial activity until the end of the
19th century, but it had gradually shifted during those 200 years toward exclusive focus on central
bank activity. The Bank of England had substantial independence for much of the 18th and
19th centuries, but by the 20th century it had essentially become an agency of the British Treasury.
Then, in June 1998, it was reborn as an independent central bank under the current Labour
government.
The Bank of Japan gained operational independence in April 1998. The Bank is still not legally
independent, a status prevented by the Japanese constitution. In addition, representatives of both the
Ministry of Finance and the Economic Planning Agency attend meetings in a non-voting capacity. But
before then, the Ministry of Finance could require the Bank to delay implementation of a change in
policy; now it can only ask. Recently, the Ministry of Finance indeed asked the policy committee of
the Bank of Japan to delay a decision to raise the Bank's target interest rate. In an exercise of the
Bank's newly attained power, the policy committee rejected the request.
The European Central Bank (ECB) began operating on 1 June 1998, and assumed responsibility for
monetary policy in the euro area on 1 January 1999. The ECB is the world's first supranational central
bank and probably qualifies as the most independent central bank in the world. The charter for the
European System of Central Banks (composed of the ECB and the national central banks of the
member countries) is an international treaty that can be changed only by unanimous consent of its
signatories. With its supranational status, the ECB is further removed from the political pressure of
national governments than even the most independent national central banks. In addition, there is no
political counterpart to the supranational ECB. The European Parliament carries out oversight hearings
on monetary policy but does not have any authority with respect to the ECB.
Independence and the Federal Reserve System
The Federal Reserve, created in 1913, was established as an independent central bank - although, at
the time, it was given no clear concept of its role in the conduct of monetary policy. The only
reference to policy goals in the original Federal Reserve Act was that the Federal Reserve was
responsible for providing an elastic currency - that is, one that would expand as appropriate to
accommodate the need for additional transactions as production and spending grew.
The major question for the founders was the degree to which the US central bank should be a public or
a private institution. Bankers wanted a largely private central bank. Populists wanted a public
institution. President Wilson and Congressman Glass steered a middle course. There would be a
Federal Reserve Board that was completely public and Federal Reserve Banks that would have
significant characteristics of private institutions. During the first half century of Federal Reserve
history, the Congress continued to focus more on issues involving the structure of the Federal Reserve
than on providing a clear legislative mandate for monetary policy or oversight of the conduct of
monetary policy.
A former Fed governor, Andrew Brimmer, in a 1989 paper entitled "Politics and Monetary Policy:
Presidential Efforts to Control the Federal Reserve", describes the record of almost "continuous and at
least public and vigorous conflicts" between Presidents and the Federal Reserve. In his view, twelve of
the fourteen Presidents between the founding of the Federal Reserve and the time he was writing
from Woodrow Wilson to George Bush - had "some kind of public debate, conflict, or criticism of
Federal Reserve monetary policy", the exceptions being Calvin Coolidge and Gerald Ford. He alleged
that Presidents resented the delegation of monetary policy by the Congress to an independent Federal
Reserve and sought ways to bring monetary policy under their influence, often by exerting direct
political pressure on the Federal Reserve, but principally through the appointment process. Examples
of the latter cited by Brimmer include Nixon, believing that the Federal Reserve had cost him the
election in 1960, replacing Chairman William McChesney Martin with Arthur Burns in February 1970
when Martin's term expired; Carter, appointing William Miller to replace Chairman Burns in 1978;
and Reagan, appointing Alan Greenspan as Chairman in 1987. For the most part, their best efforts to
appoint sympathetic choices as Chairmen have, in Brimmer's judgement, been frustrated by the
systematic tendency of Chairmen and other Board members to insist on exercising their congressional
mandate.
Thomas M Havrilesky, in a 1992 book, also provides an account of, and some attempts to measure, the
intensity of political pressure over time, based on the number of comments on monetary policy made
by Administration officials, including the President, and by members of the Congress. He concludes
that there was little pressure from the executive branch during the Eisenhower and Ford
Administrations, but many more such efforts in the Kennedy, Johnson and Nixon Administrations.
My experience on the Board is that the Clinton Administration has respected the independence of the
Federal Reserve to a degree that, given the accounts of others, may exceed that of any previous
Administration. To be sure, President Clinton has had opportunities to make appointments to the
Federal Reserve Board and he has twice reappointed Alan Greenspan as Chairman. But to my
knowledge the Administration has never made any public or private effort to influence monetary
policy.
The Federal Reserve has been technically independent of the President from the beginning, even
though the Secretary of the Treasury and the Comptroller of the Currency originally sat on the Board.
Although it is a creature of the Congress, the Federal Reserve Act delegated control over the currency
to the Board and Congress insulated the Federal Reserve from elective politics to a large degree. The
current structure of the Federal Open Market Committee was introduced in the Banking Act of 1935,
which became effective in March 1936. At that time the Secretary of the Treasury and the Comptroller
of the Currency were removed from the Board.1 The terms of governors were extended from ten to
fourteen years and the Chairman and Vice Chairman were made appointees from within the Board
with four-year terms. This structural change is often viewed as allowing the culture of independence to
flourish at the Fed.
The legislation was also a battle between the Administration and the Congress. The Administration
wanted to shift the power over monetary policy toward the centralised and presidentially appointed
Federal Reserve Board governors, a group they had a better opportunity to influence through the
appointment process. The Congress partly resisted and diluted the control of the Administration by
allowing a role for the Reserve Bank presidents on the FOMC.
During both World Wars, Treasury wanted to issue securities at low interest rates to ease the burden of
financing and the Fed went along because it felt bound to facilitate wartime financing. In addition,
during World War I, Reserve Banks bought most of the government's first $50 million certificate issue
directly from the Treasury despite strong objections from some System officials. Such direct purchases
were later eliminated and the statutory prohibition on direct underwriting of government debt is today
considered one of the principal protections of the independence of a central bank. After World War I,
the Treasury opposed raising the discount rate to combat inflation, but the Fed did so anyway.
During World War II, the Fed sacrificed its independence by agreeing to peg the Treasury yield curve
to ensure low rates for wartime financing. After the war, the Fed wanted to resume an independent
monetary policy, fearing that it would otherwise become an engine of inflation, but the Treasury was
still concerned about minimising the service cost of the debt. To resolve this conflict, an agreement
was negotiated in 1951 by Assistant Secretary of the Treasury William McChesney Martin and Fed
officials. The Congress, led by Senator Paul Douglas, also played an important role through its support
for Federal Reserve independence. Under the terms of the Accord, as it came to be known, the Fed
was no longer obligated to peg the interest rates on Treasury debt, but it was agreed that active
consultation between the Fed and Treasury would continue. That active consultation continues today.
From the end of World War II until the mid-1970s, the mandate for monetary policy was based on the
Employment Act of 1946. This legislation set out a general mandate for the government. Although it
did not explicitly refer to the Federal Reserve, it was widely understood that the act applied to the
central bank as a part of government. The act identified the government's macroeconomic policy
objectives as fostering "conditions under which there will be useful employment opportunities ... for
those able, willing, and seeking to work, and to promote maximum employment, production, and
purchasing power".
Conflict between the executive branch and the Federal Reserve erupted dramatically in December
1965. President Johnson did not want the Administration's stimulative fiscal policy undermined by
restrictive monetary policy. Chairman Martin supported an increase in the discount rate as an
appropriate step to contain the risk of higher inflation. A key vote occurred on a proposed increase in
the discount rate at a Board meeting on 3 December. Although the President tried to influence the
Chairman's position, and others in the Administration put pressure on other members of the Board, the
Board of Governors voted 4-3 to support the Chairman. Following the vote, the President summoned
the Chairman to the President's ranch in Texas. But the vote stood. The independence of the Fed was
preserved and indeed used for precisely the purpose it was intended. Subsequently, virtually everyone
agreed it had been the correct decision. The system worked.
The Congress became more involved in the monetary policy process in the 1970s. This was a response
to both poor economic performance and changing views about the importance of monetary aggregates
in shaping economic developments, especially inflation. Inflation began to rise in the late 1960s and
escalated further in the 1970s. During this period, monetarism was an increasing influence, with its
focus on the importance of limiting the rate of growth of the money supply to control inflation. But it
was the sharp recession in 1974-75 that really provoked the Congress to provide more detailed
instructions to the Federal Reserve about the objectives that should guide monetary policy.
In 1975, the House and Senate passed Concurrent Resolution 133 calling on the Fed to lower
long-term interest rates and expand the monetary and credit aggregates to promote recovery. The Fed
was also instructed to set money growth targets and to participate in periodic congressional hearings
on monetary policy. For the first time, the Congress explicitly identified the objectives for monetary
policy. The same language about the objectives applies today. Still, with its focus on the conduct of
monetary policy at a point in time (rather than on general guidelines on policy objectives to be applied
over time), the resolution was a clear instance of action by the Congress to intervene and influence
monetary policy.
The monetary policy objectives written into the concurrent resolution were added by an amendment to
the Federal Reserve Act in 1977 and were further elaborated in the Full Employment and Balanced
Growth Act of 1978, often referred to as the Humphrey Hawkins act after its co-sponsors.
Another clear attempt at political interference emerged in February 1988 when an undersecretary of
the Treasury sent a letter to Federal Reserve officials urging them to ease monetary policy. The request
was promptly and publicly rebuked by Chairman Greenspan. Having an attempt at political pressure
become public and be sharply rejected was an unusual event in the history of the relationship between
the executive branch and the Federal Reserve.
The reporting requirements in the Humphrey-Hawkins act expired in May 2000. As a result, the
Congress is now reconsidering the monetary policy oversight process. In part because the link between
money growth and nominal spending appears to be less tight than it was earlier, the role of money
growth in monetary policy deliberations has diminished and it appears likely that the Congress will no
longer require the Fed to set and report money growth ranges. However, the current language about
the objectives of monetary policy seems likely to be retained, as does semiannual testimony on
monetary policy.
Sources of independence
Central bank independence is in part the result of formal institutional features typically incorporated in
the legislation creating and defining the central bank.
The legislation creating an "independent" central bank - or in many cases revisions to such legislation
- often entirely takes away goal independence by mandating objectives for monetary policy, but
otherwise sets up a structure that confers and protects instrument independence. The most important
requirement for instrument independence is that the central bank be the final authority on monetary
policy. That is, monetary policy decisions should not be subject to veto by the executive or legislative
branches of government. Instrument independence is further protected if other institutions of
government are not represented on the monetary policy committee. A lesser protection would be to
allow government representation but only in a non-voting capacity.
Instrument independence is further facilitated by long, overlapping terms for members of the monetary
policy committee; by limited opportunities for reappointment; and by committee members not being
subject to removal except for cause - where "cause" refers to fraud or other personal misconduct but
explicitly excludes differences in judgment about policy. An intangible contributor to independence,
but arguably the most important, is the appointment of a capable, respected, politically astute, and
"independent minded" chairman.
A third important protection of independence is achieved by freeing the central bank from the
appropriations process. Many central banks have been granted the seignorage function - issuing
currency for the government - and cover the cost of their operations from the earnings on their
portfolio of government securities acquired in the process, returning the excess to the government.
Finally, it is critically important to ensure that the central bank will not be required to directly
underwrite government debt. As I noted above, the Treasury or Finance Ministry will have an
incentive to keep interest rates low to reduce the cost of servicing the government debt. Indeed,
perhaps the first principle of central bank independence is independence from the fiscal authority.
If independence is also defined in terms of assuring the ability and commitment of the central bank to
achieve price stability, this commitment can be protected by an explicit price stability mandate from
the government. That is, a government that explicitly imposes this mandate is less likely to interfere in
a central bank's pursuit of this objective. Independence, by this definition, is viewed as greatest if
price stability is the exclusive objective of monetary policy, or at least the principal objective.
Empirical studies of the relative independence of central banks
Studies of the economic consequences of central bank independence typically estimate the economic
effects by first deriving quantitative measures of the relative independence of central banks and then
estimating how this measure is correlated with average inflation, inflation variability and real
economic performance. Reviewing three of these studies will help to better understand the meaning
and sources of central bank independence and perhaps provide at least some insights into how the
Federal Reserve ranks relative to other central banks in terms of independence.
Bade and Parkin (1988) ranked the political independence of twelve industrial country central banks
on the basis of answers to questions such as Is the bank the final policy authority? and Is there no
government official (with or without voting power) on the bank board? Grilli, Masciandro, and
Tabellini (1991) also incorporated information on the length of terms of monetary policy committee
members and on policy goals of the central bank with respect to monetary policy, specifically whether
there is a mandate for monetary stability (including money growth or price stability objectives).
Cukierman (1992) also takes into account restrictions on the ability of the public sector to borrow from
the central bank. A central bank is more independent if it is protected, for example, from directly
underwriting the government debt.
Germany (prior to its participation as part of the ECB) and Switzerland have been uniformly ranked
the most independent of central banks. The United States fell in the second tier in the Bade and Parkin
rankings; was just below the most independent central banks in the Grilli, Masciandro, and Tabellini
rankings of eighteen industrial countries; and was tied for fourth place among seventy countries in
Cukierman's rankings. The Federal Reserve lost points in these rankings because of the brevity of the
Chairman's term (less than five years) and the failure to single out price stability as the unique or
principal objective.
Of these studies, I prefer Bade and Parkin's methodology for ranking independence because they
included only those institutional characteristics that afforded a measure of independence to the central
bank. Grilli, Masciandro, and Tabellini and Cukierman also included in their measures the nature of
monetary policy objectives, ranking independence higher if there is a price stability objective and, in
Cukierman's case, higher still if price stability is the only or at least principal objective. In the latter
case, a central bank with more discretion - for example, as a result of multiple objectives, as in the
case of the United States - is ranked as less independent than a central bank that has little discretion on
account of a single, precisely defined price stability objective. Of course, defining independence to
involve a mandate making price stability the single or principal objective increases the potential for an
inverse relationship between "independence" and inflation.
Accountability
Accountability means being answerable for one's decisions. Implicit in being accountable is being
subject to discipline from whomever you are accountable to for the failure to live up to your
responsibilities. Making the central bank accountable in this way involves, by definition, some
compromise of the independence of the central bank. But accountability is the critical mechanism for
ensuring both that the central bank is operated in a way consistent with democratic ideals and that the
central bank operates under incentives to meet its legislative mandate for monetary policy. On the
other hand, as I noted earlier, steps to increase accountability also create opportunities for political
interference.
Every organisation's performance is likely to be enhanced by appropriate incentives. In the private
sector, the incentives for a business are profitability and, indeed, survival. In the public sector, other
means must be found to provide incentives. Elections of course play this role for elected officials.
With central banks having been given an arms-length relationship with the electoral process, some
have suggested that central bank policymakers should operate under explicit incentive contracts. But,
for the most part, accountability is achieved for central banks both through the appointment process
and by regular oversight by the legislature.
Accountability is facilitated by providing the central bank with a specific, external (usually
legislatively imposed) mandate. Two aspects of designing the objectives for monetary policy are
important. First, a single objective (typically price stability) makes the central bank more accountable,
because multiple targets always carry trade-offs, at least in the short-run, which are subject to the
discretion of the central bank. Second, explicit numerical targets make central banks more accountable
than more general targets. Specifically, an explicit numerical inflation target makes the central bank
more accountable than a more general commitment to price stability.
There are, however, other considerations that are relevant to setting the mandate. First, if there is a
single target for a central bank, it will surely be price stability, given that monetary policy is the
principal, even unique, determinant of inflation in the long run. While a single target is more precise,
few legislatures would tolerate a central bank disclaiming any responsibility for the cyclical state of
the economy or at least failing to respond to cyclical weakness. Indeed, given the inescapable trade-off
between inflation variability and output variability, a central