Central bank independence under threat?

(Excerpt from our CEPR Policy Insight No.87, Januari 2017)

The traditional argument for CBI is based on the desire to counter inflationary biases. The recent financial crisis and the following European debt crisis have put much pressure on central banks and changed monetary policy. The altered role of modern central banks is evident in the large set of new unconventional monetary policy measures employed during the rest of the decade.

The new tools and responsibilities of the central banks come with new challenges for central bank independence. Firstly, in an environment of global debt hangover the balance of power between fiscal and monetary policy changes. With high public debt levels, fiscal
authorities may be tempted to rely on monetary policy to generate additional inflation to alleviate the debt burden. As opposed to previous decades, the threat of fiscal dominance might be particularly strong in the developed world, which has seen remarkably strong increases in sovereign debt levels.

The second risk to central bank independence stems from the consequences of central bank policies. The unprecedented size of the central bank balance sheets has far reaching implications for the financial dimension of independence. Theoretical studies differ in their assessment of the financial risk faced by central banks. Even if it is small, the financial risk should not be underestimated, as a lack of financial independence and reliance on government financing of the central bank would strongly undermine the credibility of a central bank. Credibility, in turn, is crucial for controlling inflation and inflation expectations. This calls for a very careful consideration and design of exit strategies by the central banks, i.e. policies aiming at the reduction of balance sheets to more conventional levels.

Finally, the last threat to central bank independence is also associated with the set of unconventional monetary policies employed during the crisis. Crucial for any arguments in favour of CB independence is the assumption that monetary policy has little or no redistributive consequences. The recent policies employed by central banks threaten, however, to undermine this argument, as they are far more redistributive than traditional monetary policy. Although economists have expressed serious concerns that CBI is under threat, central bank governors are less worried. Our analysis of CBI indicators before and after the financial crisis suggests that, so far, little has changed. But it may be too early to put worries aside.

Jakob de Haan
University of Groningen – Faculty of Economics and Business; De Nederlandsche Bank; CESifo (Center for Economic Studies and Ifo Institute)
Sylvester C. W. Eijffinger
Tilburg University, The Netherlands, and
CEPR, London, United Kingdom

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