Central bank independence should have a limit

Claude Lavoie is a contributing columnist for The Globe and Mail. He was director-general of economic studies and policy analysis at the Department of Finance from 2008 to 2023.

With Federal Reserve Chair Kevin Warsh facing pressure from U.S. President Donald Trump to cut interest rates, financial markets were eagerly attentive to his speech at last weekend’s Jackson Hole Economic Policy Symposium.

While investors would ordinarily have wanted to see signals of lower rates, this time around they wanted to see whether Mr. Warsh was ready to defend the independence of the Fed. By hinting that the next move might be a rate hike, Mr. Warsh calmed the market’s fears and gave the dollar a boost.

The U.S. isn’t the only place where central bank independence is under scrutiny. With public debt increasing, many governments would like their central banks to keep rates low to create fiscal room, even if doing so poses some inflation risk. In Canada, the Opposition Leader has in the past accused the government of ordering the Bank of Canada to “print money” to buy government debt, and blamed that for the high cost of living.

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In financial circles, threats to central bank independence are almost always seen as a cardinal sin that will unleash evil forces. But central banks, like any other government institution, shouldn’t get to make decisions completely detached from what citizens and their elected representatives want. People may feel high inflation risk is not as worrisome as fiscal or financial crisis risk, for example.

Debate over central bank independence has existed since the founding of the first central bank in Sweden in 1668. The current debate started with the inflation mess of the 1970s, caused largely by bad fiscal policy, misunderstandings of how the economy functions, and political meddling in monetary policy. The lesson drawn from taming that inflation was the need to reinforce the independence of central banks with a focus on price stability. So, through the 1990s, central banks everywhere gained independence, inflation remained low and the economy stayed stable. Central bankers became trusted public figures – and they used that credibility to push for even more independence.

Operational independence makes sense. Nobody wants political interference in drug approvals or environmental assessments, for obvious reasons. The same logic applies to central banks. Once given an objective, they should be free to take the actions they see necessary to achieve it. Unfortunately, the U.S. government is currently chipping away at the operational independence of many agencies.

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But the mandate of a central bank should be set democratically, not by the bank itself. This is the case in Canada but not in the U.S. In Canada, the government and the Bank of Canada jointly agree to a 2-per-cent inflation target, an agreement renewed periodically (with the next renewal due this year). The Fed, by contrast, independently adopted a 2-per-cent inflation target in 2012 without congressional approval. Congress’ actual mandate for the Fed is broader: maximum employment, stable prices and moderate long-term interest rates. Given that, it may not be unreasonable for the President to argue the Fed should weigh other factors beyond inflation alone.

Beyond who sets the mandate, there should be a few more boundaries to central bank independence.

Central banks need to work collaboratively with the government so that monetary and fiscal policy don’t work at cross purposes. This means sharing information and coming to a common view (or an understanding on why views differ) on the economic outlook – not an independent one. Central banks sometimes need the help of fiscal policy to achieve their mandate. The effectiveness of monetary policy is very limited when rates are stuck near zero, as we saw from 2008 to 2010, and 2020 to 2022, or when government spending is very inflationary and debt is so high that only low rates keep it sustainable. Keeping inflation low is a joint effort, and the latest Bank of Canada-government agreement made that clear.

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Central banks should require the government’s blessing before taking actions that will have repercussions outside their mandate. Tools such as quantitative and credit easing (used by both the Fed and the Bank of Canada at different points) have distributional and fiscal effects that arguably should be left to elected officials. The use of those tools should require explicit, ideally public, agreement with government.

Independence should not mean being free from accountability. Presumably to preserve its independence, the Bank of Canada is not required to submit a corporate plan or budget to the federal cabinet, or to be audited by the Auditor-General. The bank has also the independence to set staff pay well above the rest of government, which means less seigniorage revenue flowing back to taxpayers.

The Fed is right to push back on Mr. Trump’s wishes for lower rates. But whether we like it or not, Congress and the President have every right to change the Fed’s mandate or weigh in on some of its decisions.