SINGAPORE (Aug 2): Central-bank independence is back in the news. In the United States, President Donald Trump has been berating the Federal Reserve for keeping interest rates too high, and has reportedly explored the possibility of forcing out Fed Chair Jerome Powell. In Turkey, President Recep Tayyip Erdoğan has fired the central-bank governor. The new governor is now pursuing sharp rate cuts. And these are hardly the only examples of populist governments setting their sights on central banks in recent months.
In theory, central-bank independence means that monetary policymakers have the freedom to make unpopular but necessary decisions, particularly when it comes to combating inflation and financial excesses, because they do not have to stand for election. When faced with such decisions, elected officials will always be tempted to adopt a softer response, regardless of the longer-term costs. To avoid this, they have handed over the task of intervening directly in monetary and financial matters to central bankers, who have the discretion to meet goals set by the political establishment however they choose.
This arrangement gives investors more confidence in a country’s monetary and financial stability, and they will reward it (and its political establishment) by accepting lower interest rates for its debt. In theory, the country thus will live happily ever after, with low inflation and financial-sector stability.