The history of central bank independence (CBI) is as old as central banking. The Bank of England was chartered in 1697 as a joint stock company to purchase government debt and aid in war finance. It also was a private entity that engaged in banking activities—lending and issuing banknotes that served as currency. Because it held the deposits of other banks, it came to serve as a banker’s bank, evolving into a lender of last resort. The BOE and other early central banks were mandated to preserve price stability by adhering to specie convertibility. They did not follow countercyclical monetary policy but had limited leeway to manage the specie standard. Early CBI for the Bank of England was made accountable by facing periodic charter renewals by Parliament.
In the United States the Federal Reserve, founded in 1913, belongs to a later wave of central banks that emerged at the beginning of the twentieth century. It was created to efficiently consolidate the various circulating payment media and to provide financial stability after the disastrous bank-panic experience of the nineteenth century following the demise of the Second Bank of the United States in 1836, and to manage the gold standard. It was not explicitly mandated to conduct countercyclical monetary policy because of the founders’ belief in the real bills doctrine that the money supply would automatically self-regulate.
Congress established the Federal Reserve System as a public-private partnership with limited operational independence. The twelve regional reserve banks were governed by local boards of directors drawn mainly from the banking community. They operated as separate regional central banks issuing notes and discounting commercial paper. The regional Feds were coordinated by the executive branch–appointed Federal Reserve Board in Washington, DC. Independence from the fiscal authorities was limited by the presence of the secretary of the treasury (and the comptroller of the currency) on the board.
During World War I, the Fed’s independence was subsumed by the Treasury’s fiscal imperative for war finance. The Fed made its first policy mistake in not stemming the immediate postwar inflation boom because of pressure by Treasury to maintain its wartime bond support program.
After the war, most of the world (except the United States) abandoned the gold standard and the Fed learned in the 1920s to successfully conduct countercyclical policy. However, the Fed’s monetary policies, based on the real bills doctrine and flawed governance, led to the banking panics and depression and deflation of the Great Contraction of 1929–33. In reaction to the Fed’s overreach, the Federal Reserve System was reorganized by the Roosevelt administration. The Banking Acts of 1933 and 1935 shifted powers definitively from the regional Feds to the Board of Governors. Also, in the mid-1930s the Fed had its independence clipped by the creation by the Roosevelt Treasury of the Exchange Stabilization Fund and the Thomas Amendment.
In World War II, the Treasury’s bond price support policy made the Fed into an engine of inflation and monetarily passive. The Fed’s full operational independence was restored with the Fed Treasury Accord of February 1951, and its chairman, William McChesney Martin Jr., was relatively successful in both maintaining price stability (and the Bretton Woods peg) and stabilizing the real economy until the early 1960s.
Milton Friedman and the case against independence
Milton Friedman, writing in 1962 at a time when the Fed’s independence seemed to be working, made a strong case against CBI. He gave four reasons.
- An independent monetary authority granting unchecked power to unelected officials is not consistent with a liberal society.
- Monetary-policy-making is diverse, involving both the Fed and the Treasury through its debt management—each able to issue money with different incentives.
- The Fed’s monetary policy is intertwined with credit policy via its operations through the banking system and the governance of the Reserve banks by the banking industry.
- Monetary policy depends on the personality of the Fed’s chair, which could lead to both good and bad outcomes. Based on his historical work with Anna Schwartz, Friedman contrasted the experience of William P. G. Harding, the Fed governor responsible for the 1920–21 recession, with Benjamin Strong, whose policy sagacity was responsible for the “high tide” of the Fed in the 1920s. Strong’s untimely death in 1928 and succession by Eugene Meyer created the Great Contraction, which Friedman and Schwartz said could have been avoided had Strong lived.
Here and in his 1960 book, A Program for Monetary Stability, Friedman reiterated the classical case against the authority of even well-meaning individuals in preference to an automatic rule—his famous k-percent money growth rule. Additional ammunition in Friedman’s attack on the Fed was his 1963 argument that countercyclical stabilization policy was subject to mis-timing and long and variable lags.
Friedman posited that the Fed could be relegated to an office inside the Treasury to print money at a rate sufficient to guarantee price stability—consistent with long-run growth of the real economy and adjusted for the long-run trend in velocity.
Allan Meltzer was also critical of Fed independence, based on his reading of the Fed’s record. His critique of Fed discretion was based on its pursuit of bad doctrine (the real bills doctrine) and what he called “short-termism,” including presidential political pressure.
The modern case for independence
The two decades after Friedman’s 1962 essay witnessed the Great Inflation. Key factors in its inception in the mid-1960s and its acceleration in the 1970s included pressure by President Johnson on Chairman Martin to keep interest rates low in the face of rising inflation, consequent upon his expansionary fiscal plans to finance both the Vietnam War and the Great Society; and pressure by President Nixon on Chairman Arthur F. Burns to keep rates low to guarantee his re-election. In the first case, Martin, under pressure from LBJ, shifted from being a hard-money conservative to accommodating the Johnson fiscal agenda. In the second, Burns shifted from being in concordance with the monetarism of his student, Milton Friedman, to disallowing any role for monetary policy in controlling inflation and to being an advocate for wage and price controls.
Chairman Paul A. Volcker’s cold-turkey tight monetary policies disguised as monetarism broke the back of the Great Inflation by 1982, and along with his successor, Alan Greenspan, restored the credibility for low inflation last achieved by Martin. The Great Inflation led to major advances in monetary theory that resuscitated the case for central bank independence, and elevated it among central bankers to the same status as motherhood and apple pie. The failure of “stagflationary” policies in the 1970s and the success of Volcker’s cold-turkey strategy raised the status of rational-expectations-based theories of monetary policy within central banks. Rational expectations became influential for including expectations in monetary policy strategy as well as setting the stage for how to design central bank policies and institutions to create credibility while keeping inflation low.
The economic idea that illustrated this was the time inconsistency of economic policy, which was developed by Finn E. Kydland and Edward C. Prescott in a broad context and applied to monetary policy by Robert Barro and David B. Gordon. According to this approach, a rule is a credible commitment mechanism that ties the hands of policymakers and prevents them from following time-inconsistent policies—policies that take the past policy commitments as given and react to the present circumstances by changing policy.
A key idea from the dynamic general equilibrium model with rational expectations was that the institutional design of a central bank was important for initiating rule-like monetary policy and reducing discretion. Work by many economists made a new case both theoretical and empirical for an independent central bank (Alex Cukierman in 1992, Torsten Persson and Guido Tabellini in 1993, and Kenneth Rogoff in 1985). Unlike in Friedman and Schwartz’s view of the Federal Reserve in the 1930s, the modern Federal Reserve system created by Chairman Martin (who in the 1950s encouraged the development of research in the Reserve banks as an independent input into the policy process) thereby became a built-in force to help the Federal Open Market Committee commit.
One line of research into how to design a more independent central bank found that hiring a conservative central banker—not in the political sense, but in the sense of wanting to keep inflation low—would help with outcomes. This tied into the history of the Reserve banks when, in the 1970s and 1980s, their presidents had more of an aversion to high inflation than the average Fed governor. Another ascendant idea from the rational-expectations revolution was John Taylor’s work on the advantage of monetary policy rules over discretion. Taylor’s interest-rate-instrument policy rule, based on deviations of inflation from expected inflation and real output from potential output, outperformed Friedman’s k-percent rule and served as a simple benchmark to evaluate Fed policy actions.
The last modern development was the adoption of inflation targeting (IT) as a central bank strategy. The idea is for a central bank to announce a numerical inflation target, an implementation of monetary policy that focuses on the inflation forecast, and transparency and accountability. IT was adopted in the late 1980s and early 1990s by New Zealand, Canada, Sweden, the United Kingdom, and Australia—and finally by the Federal Reserve, which in 2012 posited a 2 percent target.
But what about Milton Friedman?
The new case for central bank independence adopted in the 1990s seemed to dismiss Friedman’s 1962 view. This was especially the case during the Great Moderation from the mid-1980s to the early 2000s. But a series of unforced errors by the Federal Reserve (and other central banks) in the past twenty years may have made Friedman’s lessons more pertinent again.
Most notable of these errors was, first, the Great Financial Crisis of 2007–8, which many argue was partially caused by the Fed keeping its policy rate too low for too long in the early 2000s to prevent a Japan-style deflation, thereby fueling the housing boom, which led to the bust leading to the crisis.
Second was the COVID-19 pandemic of 2020–1, when expansionary, wartime-like fiscal policy and accommodative monetary policy fueled very high inflation that the Fed was several quarters late in stemming. This was based on the perception that the inflation was largely caused by transitory supply shocks rather than by warlike expansion in aggregate demand. The Fed’s delay in tightening may also have been due to its adoption of Flexible Average Inflation Targeting (FAIT) in 2019, done to allow the Fed to temporarily overshoot its inflation target to end the malaise of inflation persistently stuck below its 2 percent target.
Thus, despite the new achievements in economics and policy-making, the Fed and other central banks made important policy mistakes that resonate with the bad old days described by Friedman and Meltzer.
How to strengthen the case for Fed independence
At present, the Fed’s independence is threatened by the executive branch’s pressure for it to lower rates below what policy rules and economic analysis suggest. This has echoes of the troubled days of LBJ and Martin, Nixon and Burns.
The case for preserving and even strengthening the case for independence is to improve the Fed’s communications and accountability. The late Charles Plosser, former Federal Reserve president and member of the Shadow Open Market Committee, posited a number of steps to improve the Fed’s communications and accountability.
Plosser argued that the Fed should greatly simplify its mandate to primarily focus on price stability, and within the context of the congressional-imposed dual mandate of 1977 and 1978, should return to the approach followed by Volcker and Greenspan of maintaining credibility for low inflation, which in turn would lead to greater output stability.
Plosser also opposed the Fed’s taking on mandates such as the issues of macroprudential policy, climate change, and inequality, which would just make it harder for the Fed to reach the underlying raison d’etre of central banking: maintaining stability in the value of money.
He also posited that the Fed should greatly reduce its balance sheet back to the bills-only policy that it followed before the Great Financial Crisis. This, he argued, would improve its communications and prevent it from straying into credit policy.
His final recommendation was for the Fed to adopt a policy rule of its own choosing to use as a benchmark for accountability. The Fed’s performance with respect to following the rule would be used as part of a periodic review of its policy actions in reports to its creator, the Congress. If the Fed were to depart considerably from its rule-like target, then the chairman would have to explain why—and what would be done to improve performance. A similar strategy was proposed in the Financial Choice Act of 2017, which was never adopted.
Many have argued that policy rules like the Taylor Rule depend on their underlying assumptions, the unobserved natural rate of interest, the expected rate of inflation, and the growth of potential output—all of which are unknown. Obviously, any discussion based on these rules would have to be qualified, but the general principle would still hold. An additional improvement to communications and accountability would be for the Fed to use scenario analysis to inform the public about its thinking on how its policies will deal with the potential circumstances facing the economy.
