Linking to Bennett McCallum with some puzzlement a while back, Brad DeLong asked why a higher inflation target could be seen as undermining central bank independence. I’m with McCallum on the analysis, but not on the policy conclusion. A higher inflation target would reduce central bank independence, and a good thing too.
The problem is that ‘central bank independence’ like the famous efficient markets hypothesis, comes in weak and strong forms. The weak form of central bank independence is the principle that the executive government should not direct the decisions of the central bank.
In this sense, central bank independence has always been the norm in developed countries. In Australia, for example, the government retained the power to override the central bank through a declaration in Parliament. This nuclear option was never used, but it created a strong incentive for agreement among what was then called the ‘offical family’.
Central bank independence as it operated from the 1990s was much stronger. The extreme form, unsurprisingly, emerged in New Zealand, then the darling of free market reformers. The Governor of the Reserve Bank of New Zealand, Don Brash was appointed on a contract (the Policy Targets Agreement) that required him to maintain inflation rates between 0 and 2 per cent, and otherwise gave him complete independence (a nuclear option allowing the government to scrapt the PTA altogether was retained).
The NZ approach to monetary policy was a disaster. Whereas Australia’s more flexible Reserve Bank steered the country through the Asian financial crisis, New Zealand was pushed into an unnecessary recession.
But less extreme versions of this approach were adopted throughout the world, and appeared, during the Great Moderation, to be successful. The key elements were
- Inflation targeting, typically with a range of 2 to 3 per cent
- Comprehensive financial deregulation
- The abandonment of active countercyclical fiscal policy
- Interest rate adjustments as the sole instrument of monetary policy
Taken together, these measures gave central banks almost complete independence from government.
If the policy responses adopted in the immediate aftermath of the crisis, including active fiscal policy and regulation of the financial system to maintain systemic stability are continued, this strong form of central bank independence would be at an end. Unsurprisingly, central banks have fought hard to return to the status quo ante, doing their best to promote fiscal austerity and resist any radical change in financial regulation.
A higher inflation target would be an even more direct repudiation of central bank independence. Not only would it facilitate active fiscal policy but it would underscore the point that the greatest financial disaster in history occurred during the era of strong central bank independence and as a result of the combination of central bank independence and financial deregulation, previously cheered on as the cause of the Great Moderation.
To paraphrase Clemenceau, monetary policy is too important to be left to central bankers. Governments will inevitably held responsible for the outcomes of macroeconomic policy, so they need to take a substantial share in shaping it.