ECB warns central bank independence key to price stability
The European Central Bank has warned that weakening central bank independence risks undermining price stability, as new research reviewing 50 years of global data showed that independent central banks are consistently better at controlling inflation.
The analysis, published in an ECB blog, examined the performance of 155 central banks over half a century to assess whether independence from government influence improves monetary policy outcomes.
The research found that central banks shielded from political control are able to pursue more credible monetary policies, making them more effective at keeping prices stable.
The findings come amid renewed political pressure in some countries for central banks to cut interest rates regardless of underlying macroeconomic conditions.
The ECB blog argued that independence allows central banks to focus fully on their mandate, which today is primarily the preservation of price stability.
By contrast, politically dependent central banks may face pressure to prioritise short-term economic objectives, leaving them less able to contain inflation.
Drawing lessons from the 1970s, the analysis recalled how governments and central bankers once believed there was a stable trade-off between unemployment and inflation.
At the time, policymakers assumed higher employment could be achieved at the cost of only moderately higher inflation, which encouraged demands for looser monetary policy.
This assumption collapsed during the oil crises of the 1970s, when high inflation coincided with rising unemployment.
It was in this environment that the idea of central bank independence began to gain widespread support.
The blog highlighted the so-called time-inconsistency problem, which arises because monetary policy affects inflation only with long and variable delays.
Governments facing elections may be tempted to stimulate the economy in the short term, even if this leads to higher inflation later.
Independence was therefore seen as a way to counter this bias by enabling central banks to commit credibly to long-term price stability.
The research also pointed to a broad consensus that greater independence is associated with lower inflation without harming economic growth.
However, critics have argued that this relationship could reflect correlation rather than causation.
Other factors, such as globalisation or the Great Moderation period of low volatility in the United States from the 1980s until the 2007 financial crisis, may also have contributed to stable inflation.
To address this concern, the study compared economic conditions before and after institutional reforms that strengthened central bank independence.
The panel analysis covered reforms in 155 countries over the past 50 years and controlled for a wide range of economic and institutional factors.
The results showed that independence contributes to price stability because it enhances the credibility of monetary policy.
In democratic systems in particular, independent central banks were found to be able to take a more conservative approach to inflation control.
As a result, they may not need to raise policy interest rates as aggressively to achieve price stability.
The study explored how a lack of independence can undermine credibility if markets believe governments may interfere with monetary policy.
Where governments have no say in monetary decisions, central banks are more likely to prioritise price stability over short-term political objectives.
The analysis also examined how political systems, fiscal policy frameworks and exchange rate regimes influence the effectiveness of independence.
It found that reforms enhancing independence have the strongest impact on inflation in democratic countries, in countries with flexible exchange rates, and in those without formal monetary policy targets.
The quantitative work drew on annual macroeconomic data from the World Bank and the International Monetary Fund.
It also relied on a legal index measuring central bank independence on a scale from 0 to 1.
The index was constructed from an assessment of 42 legal criteria, including how board members are appointed, limits on lending to governments, financial autonomy and reporting obligations.
To test credibility, the study measured how closely actual inflation outcomes matched official targets.
Smaller deviations from targets, whether overshooting or undershooting, were taken as evidence of higher credibility.
The results showed a clear positive relationship between independence and credibility.
Further analysis using the local projections method confirmed that this relationship is causal.
An increase of 20 basis points in the independence index, which reflects the average global reform between 1990 and 2020, was found to raise credibility by 6 per cent after ten years.
The ECB blog concluded that the experience of the past 50 years demonstrates the importance of safeguarding central bank independence.
At the same time, it stressed that independence should be balanced with democratic accountability to maintain legitimacy.
The warning was clear that weakening independence undermines the credibility of monetary policy and puts price stability at risk.