Central Bank Independence and Macroeconomic Performance - Statistics Project Example

Central Bank Independence and Inflation Name: Institution: Instructor: Date of Submission: Introduction Independence of the central bank refers to the freedom granted to the policy makers of monetary authorities from influence by the government or direct political influence in conducting their policy. It is noted by Debelle and Fischer (1994) that economists have regularly attributed political pressures as the reason behind central banks preferring economic expansions or having out of reach output goals. This is because certain elected officials may be aggravated by electoral contemplations or valuing economic expansions in the short term, thereby overlooking the long run inflationary consequences of expansionary policies. On such instances where the ability of elected officials to alter the monetary policy ends up bringing forth high inflation rates, then those economies with independent central banks that are not subjected to such pressures would experience lower inflation rates (Rogoff, 2003). The bank of England for instance, has instrument independence even though it lacks goal independence. With its inflation authorization or responsibility set by the government, the bank is in a position to set its instruments with no direct influence from the government. The same case applies to the Reserve Bank of New Zealand which sets its policy targets agreement with the government but the reserve bank retains the authority to set its instruments free from any interference. The Federal reserve of the United States and the European Central bank, both have total absolute instrument independence (Crowe & Christopher, 2007). According to one of the principles of macro-economics, continuous growth rates of a country’s money that is kept in stock which is more than the country’s production of goods and services will at long last lead to high and increasing inflation rates. To certify whether countries with independent central banks actually have lower inflation rates, there is need to look at the specific measure of that independence. It is noted by Alesina and Summers (1993), that nations that had given higher levels of independence to their central banks also happened to experience minimal average levels of inflation from the year 1955 to 1988. This relationship is shown in the chart below; Figure 1. In recent years inflation in the global context has slowed stridently since the mid 1990’s. This is as shown in figure two below. However this sluggishness of global inflation rates is attributed to developments in emerging markets and developing countries as the descent in the more developed countries was experienced much earlier that is in the early 1980’s (Alesina & Summers, 1993). Figure 2 World CPI Inflation SOURCE: International Monetary Fund CPI Inflation in the Advanced Countries SOURCE: International Monetary Fund CPI Inflation in Emerging and Developing Countries SOURCE: International Monetary Fund According to Bade and Parkin (1984), the global turn down in inflation from the late 1980’s was as a result of many reasons. These include; more commitment to ensuring prices are stabilized, growth in rates of productivity, amplified competition and elasticity of labour and product markets that were brought about by the forces of globalization. It is noted by Rogoff (2003), that higher levels of central bank independence is also a key contributor to the lower rates of inflation globally. As indicated in the table below, between the year 1980 to the year 1989, there was a notable rise in central bank independence. Even though this trend was more notable in the more developed countries, it was also noticeable among up-and-coming markets and developing countries. Central bank independence was in fact aided by many reforms that were made during 1990’s as a response to the high inflation rates. The continuous decrease in inflation rates in most countries can with no doubt be attributed to the tendency of most countries enhancing central bank independency. Table 1 Measures and Frequency Distribution of Central Bank Independence Advanced Economies Emerging & Developing Economies 1980 - 89 2003 Net Change 1980 -89 2003 Net Change Weak Independence 13 8 -5 32 6 -26 Moderate independence 8 5 -3 19 49 30 Strong Independence 0 13 13 0 15 15 NOTE: the measurement of the central bank independence on the table above is measured on a numerical scale from 0 (no independence) to 1 (complete independence). For this table, weak CBI is defined to include those banks with a scale from 0 to less than 0.4; moderate independence is defined as those banks from 0.4 to 0.8; strong independence is for banks with a CBI measure of 0.8 or above. The Federal Reserve's ranking on this scale is 0.47, and the ECB's ranking is 0.83. To ensure that central bank independence is attaining its targets as expected, there is need to put forth a rule based framework to ensure that the policy makers are not so discretionary and also see to it that there is good economic performance. Bade and Parkin (1984), indicates that there is a dire need to encourage more predictable policies that have been proven to work and dampen the spells of carefulness and loss of genuine independence where it has not worked as expected. In Sweden the independent central bank has maintained its interest rates just over the ZLB, despite the prices having been falling. The bank had cut down its rates in 2009 to 0.25%, however the rate was increased to 1% in 2010 and 2% in the year 2011. The rate has however been cut to 1% but the bank is adamant to cut the rates beyond that even though prices are flat and have been falling through out the year 2013. This is contrary to the bank’s policy as it has a clearly laid target of 2% for inflation. It is quite clear that with such a monetary policy as that of the Swedish central bank, it risks undermining the legitimacy of independence of the central banks. At times delegation tends to undermine the democratic process. It is not right for central bankers, or for the officials/experts who sit on monetary policy committees, to take decisions that can potentially impact negatively on the citizen’s lives. That is one of the reasons that Alesina and Summers (1993) argue that, successful and effective delegation tends to occur or be realized when there is a wide consent on what comprises a meaningful and realistic policy. In actual fact the work of independent central banks was to keep the rates of inflation on the low. This has been done to some extent and within a certain scope, but the principle task and the ways or manner through which that was to be achieved, was clearly stated and had global support. Cukierman (2008) notes that, it is not acceptable for central banks to allow inflation rates to be continuously below target as the accord on the idea of independence of the bank will evaporate. This arrangement in Sweden is different from the one in the U.K. In the United Kingdom, there is a separate financial policy committee that works in alliance with, though independent of the monetary policy committee. The financial policy committee is the one mandated with macro prudential policy. The monetary policy committee can then decide either to approve or disapprove on the call by the financial policy committee. In such a case as this of the United Kingdom, the arrangement works best since both of these committees are represented by professionals out of the central bank and more specifically the members of the financial policy committee are not just present or past bankers. The advantage with this setting is that before the monetary policy committee even starts to reflect on giving a chance to fears of financial instability to influence its interest rate judgment, the financial policy committee has to first tire out all other means that they have at their retention. Such an institutional arrangement shows that it is for the interest of others in this case the citizens, and not who set the interest rates with intentions such as to protect borrowers of mortgage from their own impending recklessness. Crowe and Meade (2007) notes that, it is therefore important to initiate legal Provisions even though they are not satisfactory so as to ensure there is independence of the central banks. This is because there are always intentions to go round the legal framework by some individuals with an intention to influence the behaviour or policy of the central bank. Debelle and Fischer (1994) notes that, there is therefore a need to have a watch dog so as to see to it that these intentions do not actually translate into actual actions. This is a task that should involve not only the independent central bank alone, or the political system, but the society as a whole with the media and public opinion on the fore front. Despite all these setbacks with regard to central bank independence in some countries, it is important though to understand the importance of central bank independence especially in the modern monetary systems. This is because with the paper money, and where government liabilities symbolize means of payment and also have buying power, there is always a looming inducement for the various governments to use such money in an opportunistic manner. Such enticement is derived from the fact that formation of money has a positive effect in the short term on growth and employment; while on the other hand, the costs in terms of elevated inflation are paid over a longer period hence having long term effects. Central bank independence is therefore a way to preserve policy makers against being tempted to use the monetary policy in a imprecise way. Even though the temptation is not completely eliminated but at least it’s controlled. It is for this reason that the central bank independence is highly supported by citizens of the various countries. This is also because there is adequate practical proof to show that the central bank independence is key to bringing about lower inflation which then enhances a more stable environment for economic and employment growth (Crowe & Meade, 2007) Despite there having a statute governing the European union member countries with regard to the central bank independence, it is clearly noticeable that there is not yet a complete understanding by the political authorities and the society at large in some of these countries of the reasons and benefits core to the independence of the central bank and the commitments that calls for these nations to enhance the running of an independent central bank. Inability to fully enhance central bank independence is a violation of the treaty which states in article 7 that the provisions on central bank independence apply to all European Union member states apart from United Kingdom, which has a special delegation (Bade & Parkin, 1984). Member countries are therefore expected to have granted full independence to the central bank before their time of accession to the European Union which is actually not the case in real practice. It is noted by Cukierman (2008) that, the increase in central bank independency was more notable in developed countries. However, this independency ranged from weak, moderate and strong independence. Most of these countries however moved from slow and moderate to strong independence on joining the European Union which then made them members of the European Central bank. The European Central bank is deemed to be strongly independent as a result of the Maastricht treaty. Despite the fact that most efforts to reduce the rates of inflation over the past twenty years have been directed towards ensuring the independence of the central bank, there is sufficient evidence to suggest that Central bank independence is a necessary tool though not totally sufficient to produce good inflation performance over time. For instance, the Federal reserve of the United States has not become that much independent as shown by the measure on the table, but still the country has been able to ensure that its inflation rate has decreased notably from the 1970’s and the 1980’s. However, it is also important to note that the independence of the central bank has been central to the decline in inflation rates as from the 1980’s in the developing countries and emerging markets worldwide. According to Rogoff (2003), those central banks that tend to be independent and inflation averse usually minimize the average inflation, but on the other hand, tend to raise the output variability. He argues that despite reducing the inflation bias through the central bank independence, it is made possible by the time-inconsistency problem but the inflation rate stabilizes less. This is however in contrast with the indication of Alesina and Summers (1993) who argue that, due to the fact that most countries with independent central banks are associated with more unpredictability of growth or unemployment. Thus, they state that central bank independency brings about low rate of inflation at no obvious authentic costs. Rogoff (2003) however notes that, by shielding monetary policy from political pressures, a central bank that is independent can reduce the political unpredictability thus bringing forth an overall effect of independence on out put variability. This is as noted by Alesina and Summers (1993) on the lack of connection between the independence of the central bank and the output variability. It is actually possible that when the politically induced output variability is principal, a more independent central bank diminishes the average inflation and the variance of output. According to Hanke and Kwok (2009), quite a number of nations have implemented reforms aimed at availing more independence to their monetary authorities from direct political influence. This statement is justified by past research that shows that central bank independence is negatively related or connected with the average inflation especially among the developed countries. Rogoff (2003) also argues that, despite the central bank independence playing a role in reducing the inflation rates globally; it seems as if the present law with regard to the central bank independence has not been fully effective. This is seen from some of the activities that the central banks engage in that raise questions about the independence it has from the government. For instance, despite the independence of the Bank of England in the past few years, the bank has not shied away from ignoring its inflation target. This has also been the case with the European Central Bank as seen from purchasing autonomous debt arguing that it’s for the purpose of gaining financial stability. Such instances show that in general, central banks have been acting contrary from policies that lead to both price and output stability. References Alesina, A. & Summers, L. 1993. Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence. Journal of Money, Credit, and Banking, Vol. 25, No. 2, pp151-62. Bade, R. & M. Parkin. 1984. Central Bank Laws and Monetary Policy. Department of Economics, University of Western Ontario, Canada Crowe, C. & Meade, E. 2007. The Evolution of Central Bank Governance around the World." Journal of Economic Perspectives, Vol. 21, No. 4, , pp. 69-90. Cukierman, A. 2008. Central Bank Independence and Monetary Policymaking Institutions—Past, Present and Future. European Journal of Political Economy, Vol. 24, pp. 722-36. Debelle, G. & Fischer, S. 1994. How Independent Should a Central Bank Be?in J.C. Fuhrer (ed.), Goals, Guidelines and Constraints Facing Monetary Policymakers. Federal Reserve Bank of Boston, 195-221. Hanke, S. & Kwok, A. 2009. On the Measurement of Zimbabwe's Hyperinflation. Cato Journal, Vol. 29, No. 2, Spring/Summer, pp. 353-64. Rogoff, K. 2003. Globalization and Global Disinflation." Proceedings from the Federal Reserve Bank of Kansas City Economic Symposium, pp. 77-112. Read More