Does Central Bank Independence Truly Exist? – McGeever, Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) – The debate over the independence of the Federal Reserve is resurfacing and could become a significant issue for investors if Donald Trump wins the upcoming U.S. presidential election on November 5.

In July, the former president and Republican candidate stated that he would allow current Fed Chair Jerome Powell to complete his term, which ends in 2026, although he added that this would depend on whether he believed Powell was making the right decisions. Last month, Trump further suggested that the sitting president should have a say in the Federal Reserve’s decisions.

While central banks have achieved greater operational independence in recent decades—primarily through the adoption of inflation-targeting—the clarity of their political and legal independence remains contentious.

Ideally, central banks would set policy solely based on hard economic data, unaffected by the political influences of the day. However, this notion might be overly optimistic, yet it isn’t necessarily detrimental.

For instance, responses to the Global Financial Crisis and the COVID-19 pandemic involved interlinked and often coordinated fiscal and monetary policies, which helped nations avert severe economic and financial crises.

This approach has led to soaring government debt, much of which is held by the central banks themselves. Although this debt was acquired on the secondary market rather than through direct monetization, it still represents one branch of government effectively lending to another.

This raises the question: Does such politically motivated spending pose a threat of hyperinflation, contradicting the fundamental aim of nearly every central bank, which is managing inflation?

Certainly, inflation spiked after the Fed’s substantial stimulus measures. However, inflation remained below the U.S. central bank’s target for over a decade after the 2008 crisis, despite the Fed’s expanded balance sheet, and surged only in 2022 due to a combination of massive money creation, direct cash transfers, global supply chain disruptions, and an energy crisis triggered by geopolitical tensions.

Thus, while coordinated fiscal and monetary policies might have contributed to the inflation increase, the U.S. economy remains strong, with inflation trending back toward the Fed’s 2% target. This raises the question: Was the outcome truly negative, especially when considering the potential consequences of inaction?

Robert Skidelsky, a distinguished professor and UK lawmaker with views contrasting with Trump’s, argues in his article titled "The Myth of Central-Bank Independence" that the government should have a more significant role in monetary policy. He points out that "interest rates influence not only the value of money but also unemployment, growth, and income distribution," suggesting that monetary policy should be under the control of elected officials.

In a more recent piece, "The Limits of Central-Bank Independence," Stefan Gerlach, a former deputy governor of Ireland’s central bank, contends that central bank independence is not an absolute necessity for achieving low inflation. He cites Singapore as a case study, where the Monetary Authority of Singapore has maintained an average inflation rate near 2% since adopting its monetary policy framework in 1981, using exchange rates as its primary tool.

Interestingly, despite having four government ministers on the MAS board, Singapore successfully achieves stable inflation without true central bank independence, scoring poorly in recent global rankings that assess central bank independence based on various criteria.

As evidenced by the global response to the financial crisis and the pandemic, central banks are working more closely with governments today than in recent history while maintaining a façade of independence, and this collaborative effort has been relatively effective.

In conclusion, even if the concept of central bank independence is somewhat fictional, it may still serve a valuable purpose.

(The opinions expressed here are those of the author.)