THE ECONOMIC EFFECTS OF CENTRAL BANK INDEPENDENCE

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By Kenneth A. Kriz

Many observers were alarmed when President Donald Trump began to criticize and seemingly threaten the position of the Federal Reserve Board of Governors, especially Federal Reserve Chairman Jerome Powell. Concerns began to mount about the independence of our central bank and the potential implications of any loss of independence. In this article, I will discuss the potential economic effects of the current situation in light of the academic literature on central bank independence (CBI). I will focus on why CBI is important for achieving stable macroeconomic outcomes, why it might not be that important or even work against achieving certain policy objectives, what economic effects I might see with lower levels of CBI and developments to be especially concerned about.

To start the discussion, I must first define what CBI means. To paraphrase the first papers to examine its effects, CBI means the extent to which decisions taken by a central bank are free from political influence. Most academic research uses a continuum of CBI to assess its effects. The Fed is generally thought of as being at the higher end of the CBI continuum (more independent), but a few other countries' central banks are often rated as even more independent. The concern about the current situation to an economist is that CBI will be reduced by the constant political pressure and any structural changes to the Fed Board that the current president is able to achieve, not that it will be "lost."

The importance of a high level of CBI for achieving macroeconomic stability was set forth in theory by Rogoff (1985). His model was built on earlier theories that voters (and their elected political representatives) had an "inflation bias." Central banks managed by political appointees would be more responsive to elected officials and incorporate the inflation bias into policy. This would create conditions for higher-than-optimal long-run inflation, which in turn would reduce long-run growth by reducing the efficiency of the economy through things like "shoe leather costs" of individuals and businesses expending effort searching for lower-priced goods and services. Rogoff proposed that monetary policy could be improved by appointing a central banker with a lower inflation bias than voters and their representatives, which implies independence (CBI). Early empirical studies indicated a fairly strong negative relationship between measures of CBI and long-run inflation rates, corresponding to the predictions of the Rogoff model (see, e.g., Alesina and Summers, 1992). However, more recent research has found a weaker and less consistent relationship between CBI and inflation. Importantly, recent research also finds several other factors that influence the relationship, moderating its effects.

Beyond this, CBI may have certain unintended consequences or result in monetary policy problems during economic downturns. While voters and elected officials may have an inflation bias that is detrimental in the long run, in the short run during economic downturns this bias may be helpful. By emphasizing holding down long-run inflation during times of economic contraction, independent central banks may choose a tighter-than-optimal monetary policy, deepening or lengthening the contraction and fighting against countercyclical fiscal policy. This "time inconsistency" in short-run employment goals is part of the trade-off for gaining lower long-run inflation. So, there may be a reason to reduce CBI somewhat during economic downturns through policy coordination with the executive branch. In the U.S., this coordination is with the Treasury Department, to avoid being trapped in prolonged economic downturns (Blinder, 2013).

While the results of empirical studies on the relationship between CBI and inflation have been mixed, more consistent results have been found for the relationship between central bank credibility and economic outcomes. Credibility is widely believed to be the most important aspect of central bank monetary policy. One of the main purposes of Fed policy is to set expectations for the path of the economy. Reducing interest rates must be a signal that the Fed Board believes objectively that the economy is slowing, just as increasing rates must be a signal that the Board believes the economy is running too hot. Political attacks on central banks reduce the credibility of the bank's decisions, regardless of legal CBI, unless the pushback from the bank is strong enough to maintain credibility. Recent empirical research (Binder, 2021) finds a strong relationship between political pressure on central banks, long-term inflation rates and the persistence of inflation over time, even controlling for CBI. CBI was not found to be a statistically significant indicator of inflation or inflation persistence. In a related paper, Nurbayev (2017) finds a significant effect of the rule of law on inflation level and inflation volatility, controlling for CBI, which again proves insignificant in this analysis. The rule of law plays a moderating effect in the relationship between CBI and inflation.

In the end, the deterioration of the rule of law and increased political pressure on relatively independent organizations might be the most pernicious aspect of what has been happening in the political economy of the United States recently. The actions of the current administration are already weakening the credibility of the Fed. As perceptions of political pressure on the Fed increase and the perceived rule of law weakens, it may be harmed beyond repair. At some point, the Fed will begin to lose its ability to influence macroeconomic policy and potentially make us worse off as a country.

Author: Kenneth A. Kriz, Ph.D. is the University of Illinois Distinguished Professor of Public Administration at the University of Illinois at Springfield. Dr. Kriz conducts research focusing on subnational debt policy and administration, public pension fund management, government financial risk management, economic and revenue forecasting, and behavioral public finance. A nationally recognized scholar for his work on public finance and quantitative data analysis, Dr. Kriz has published over 50 academic journal articles and book chapters along with books on quantitative research methods in public administration and tax increment financing, a frequently used economic development incentive. Dr. Kriz' newest book:Forecasting Government Budgets, will be published in Fall 2022 by Lexington Books. Dr. Kriz has consulted with several public and nonprofit organizations on financial and economic matters, including the cities of New York City, Minneapolis, St. Paul, Omaha, and Wichita, and the states of Nebraska and Kansas. He served as Vice-Chairperson of the City of Omaha, Nebraska Civilian Employees Retirement System from 2006 to 2011 and on the Board of Trustees of the Wichita, Kansas Police and Fire Retirement System, and on the Joint Investment Committee for the city-,,s pension funds from 2014 to 2018. Dr. Kriz was a Fulbright Scholar in the Republic of Estonia during the academic year 2004-05 and a Fulbright Senior Specialist in the Czech Republic in 2008. Most recently, Dr. Kriz served as the Interim Vice Chancellor for Finance and Administration at UIS from 2023 to 2025.