A central bank calling the shots on monetary policies is a must for the 21st century economy. Furthermore, these banks regulate the movement of credit and money within a nation, with the potential to impact employment, inflation, economic growth, and financial stability. If handled strategically, these factors can give politicians a boost in the run-up to an election while simultaneously causing long-term economic implications.
Consequently, central banks have been granted considerable freedom to independently set interest rates without being influenced by political agendas. This has happened recently all over the world. The gold standard of managing national finances has been data-driven, technocratic monetary policymaking since the early 1990s, as opposed to politically driven decisions.
In nations like Sweden and Switzerland that have autonomous central banks, the rate of inflation has been comparatively low and steady. In contrast, nations like Argentina and Turkey, where central banks have to dance to their political bosses’ tunes, saw more periods of severe inflation.
However, politicians across the nations have put more pressure on central banks over the past ten years, even though independence is perceived to be effective. They want voters to be grateful for a booming economy and low-cost loans.
The ‘Trump’ example
Donald Trump is one example. During his presidency, Trump called for lower interest rates and attacked his selection to lead the United States Federal Reserve. Now, if Trump wins in 2024, some of his supporters have developed plans that would see the Republican participating in Fed meetings to determine interest rates or, at the absolute least, succeed current Fed Chair Jerome Powell.
As per the latest Bloomberg Markets Live Pulse survey, 44% of respondents said they expect Trump to seek to politicise the central bank or limit its power if he returns to the White House. Overall, they put a probability of 40% on the Fed losing its autonomy under a second Trump administration.
The unlikely situation of the Fed’s independence being cut down upon will likely rock financial markets, apart from undermining investors’ faith in the Fed as overseer of the world’s largest economy and exposing it to political pressure to cut interest rates. The Trump circle’s “Fed Plans” seem an ill-timed one, given the fact that the central bank is already facing the pressure of cutting down its more than two-decade-high benchmark rate.
“More than one-third of the respondents said that Trump would likely use social media and public appearances to jawbone the Fed, though 14% anticipate that he will try to demote Chair Jerome Powell before his term ends in 2026,” Bloomberg stated further.
A report from The Conversation stated that experts do not find it shocking when policymakers attempt to sway central banks. Even in the wake of independence, monetary policy has always been partisan. For starters, central banks are still a part of the government apparatus, and any independence that has been bestowed upon them can always be revoked by amending the law or reversing long-standing policies.
Furthermore, the incentive for politicians, particularly those before an election, to intervene in monetary policy stems from the fact that low interest rates provide a powerful and expedient way to stimulate economic growth. Despite the understanding that there are consequences to challenging an independent central bank, potential negative reactions from financial markets or the risk of inflation, the temporary control of a powerful policy instrument can be too enticing to resist.
Legislating independence
In general, central banks are shielded by laws that grant their leadership lengthy terms, permit them to concentrate their policy efforts on inflation, and severely restrict lending to other branches of the government.
Naturally, no legislation can foresee every scenario that might arise in the future. This could lead to opportunities for illegal activity or political meddling. Additionally, central bankers occasionally face abrupt terminations.
However, laws do serve to rein in politicians. For example, laws shielding central banks from political meddling have assisted in lowering inflation and limiting central bank lending to the government, even in authoritarian nations.
Political candidates are appointed to leadership positions in central banks. According to a 2023 study, the head of state appoints roughly 70% of central bank leaders, either on their own or in coordination with other executive branch officials. This guarantees that the central bank’s preferences align more closely with those of the government, which can strengthen the bank’s legitimacy in democracies but increase its susceptibility to political influence.
Alternatively, the legislative branch or even the board of the central bank may be involved in appointments. Within the US, the Federal Reserve Board is appointed by the president, but the Senate has the authority to reject candidates who are unorthodox or incompetent.
Furthermore, many central bankers hold their positions long after the individuals who nominated them were voted out of office, even in cases where appointments are political. By the end of 2023, five years will be the most common duration for governor appointments, with legal mandates lasting six years or more in 41 countries.
The low inflation objective
Globally, low inflation was the primary objective of all but six central banks as of 2023. However, a lot of central banks are mandated by law to undertake additional, sometimes contradictory objectives, like full employment, financial stability, or support for governmental policies.
Around 38 central banks fall into this category, either because they have more complicated objectives or the explicit dual mandate of employment and price stability. For instance, in Argentina, the central bank’s mandate is to provide ’employment and economic development with social equity.’
Central banks may become politicised as a result of competing interests. Both stable prices and maximum sustainable employment are two of the Federal Reserve’s dual mandates in the US. Economists have contended that low inflation is a necessary condition for maintaining high employment rates, and these objectives are frequently complementary.
Nevertheless, the Fed’s dual mandate has become a hotbed of political manoeuvring during periods of concurrently high unemployment and inflation, such as the late 1970s or the end of the COVID-19 pandemic in 2022. The primary focus of the central banks of at least twenty-three countries has shifted from inflation to other areas since 2000.
Limits on government lending
To aid governments waging wars with funding, the first central banks were established. Today, however, the primary means of safeguarding price stability against unmanageable fiscal spending is to restrict lending to governments.
The results of failing to do so are littered throughout history. To help their governments meet their spending targets, Latin American central banks, for instance, printed money in the 1960s and 1970s. However, it did not ensure political stability or growth and instead led to severe inflation.
These days, lending restrictions are closely linked to lower inflation in developing nations. Furthermore, highly independent central banks have the power to impose their own loan conditions or reject requests for funding from governments.
However, nearly 40 nations have reduced the ability of their central banks to impose restrictions on central government funding over the last 20 years. In the more extreme cases, the central bank has been transformed into a possible source of funding for the government, as in Belarus, Ecuador, or even New Zealand.
Scapegoating central bankers
Recently, governments have made calls for meetings with central bank leadership, criticised bank policy in statements, and pushed for lower interest rates as ways to exert influence over central banks. The same central bankers have also been held accountable by politicians for several alleged misdeeds, including failing to foresee economic shocks like the financial crisis of 2007–2009, going beyond their authority through quantitative easing, and causing extreme inequality or instability in the process of attempting to save the financial industry.
Furthermore, major central banks have had difficulty controlling inflation since the middle of 2021, which has prompted politicians who support nationalism and anti-democracy to question the benefits of an arms-length relationship. Yet historically, reducing the independence of central banks has always resulted in high inflation.