In the recent past, the political and economic backdrop has changed dramatically. Inflation is far too high almost everywhere, and central banks are raising their policy interest rates at a time when stocks of government debt are large. In some places, central bank independence is being publicly called into question. Threats to central banks’ independence, and thus to their ability to fulfil their monetary policy mandates, are particularly acute in the current economic environment.
History teaches us that when central banks are closely tied to the fiscal authority, expansionary monetary policy is often used, directly or indirectly, to finance government deficits. Time and again, this has ended in high inflation. Price stability can only be achieved with an independent monetary policy, i.e. without political pressure on the central bank. It is thus important to avoid fiscal dominance, that is to say fiscal considerations holding sway over monetary policy.
Fiscal dominance can take the form of either misused or misguided monetary policy. Misused monetary policy consists of the central bank explicitly deciding to help government finances, and reflects a lack of good and stable governance. Misguided monetary policy occurs when central banks’ judgement is altered to avoid political pressure, which leads to policy mistakes that help government finances.
To fight inflation effectively, central banks need independence – precisely at a time when such independence is at risk because of high inflation. So how can central bank independence best be ensured? First of all, the dividing line between monetary and fiscal policy must remain clear. The most effective way of achieving this is for central banks to have narrow mandates focused on their core task: ensuring medium-term price stability. Second, monetary policy should not be misused for government finances. Financial conditions should now be tightened with a clear focus on bringing inflation back to target. And third, monetary policy should not be misguided, thus an underlying expansionary bias is to be avoided. By doing their job well, central banks prove that they are using their independence in the best interests of society.
Full story here Are you the author?Tags: Featured,newsletter
