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Speech by Bank of Greece Deputy Governor John (Iannis) Mourmouras: “Central bank independence revisited in the era of unconventional monetary policy”

24/11/2016 - Speeches

“Central bank independence revisited
in the era of unconventional monetary policy”*
by
Professor John (Iannis) Mourmouras
Deputy Governor, Bank of Greece
Former Deputy Finance Minister

The intellectual roots of central bank independence (CBI) can be traced back to the rational expectations revolution, pioneered by the Chicago School in the 1970s. Rational expectations played a pivotal role in breaking the intellectual deadlock in the effort to address the 1970s stagflation phenomenon. With regard to monetary policy, seminal work by Kydland and Prescott, and Barro and Gordon on the time inconsistency of optimal rules, showed that under discretionary monetary policy the interaction of rational private agents with an equally rational government generates a second-best Nash equilibrium involving an inflation bias whose size increases with the degree of output-gap aversion and which does not entail any sustainable output gains. To address the problem of inflation bias, monetary policy should be conducted under a technology of credible commitment to low future inflation rates so that private inflation expectations are anchored to equally low levels. Furthermore, CBI can be beneficial in ensuring sustainable public debt dynamics, as theoretically shown elsewhere by the author in a dynamic game set-up (see below).

Monetary policy in the post-global crisis period

The global financial crisis of 2008 and the ensuing European sovereign debt crisis have fundamentally changed the operational framework of independent central banks. For instance, central banks have been given new macro-prudential tasks, such as the supervision of systemic banks in the EMU, conducted by the ECB since 2014. Another important change is the situation on the ground: Rather than preventing excessive inflation, price stability in the post-crisis era is about preventing deflation. As a result, all major central banks have employed non-standard monetary policy tools in recent years. These include the provision of emergency liquidity and credit support to banks and other financial institutions, extending the definition of assets accepted as eligible collateral when providing loans on a short- or medium-term basis; negative base rates; and introducing quantitative easing (QE) programmes which saw central bank balance sheets expanded considerably: since 2008 the Fed’s balance sheet has more than doubled; the Bank of England’s balance sheet trebled; while the ECB’s balance sheet has also expanded considerably, particularly since the introduction of the ECB’s QE programme in 2015 (the Eurosystem has already purchased €1,306 billion of assets under the expanded Asset Purchase Programme, including €1,149 billion under the Public Sector Purchase Programme). Consequently, in the present context one single important question arises: if and how the concept of an independent central bank has been undermined, in an era of unconventional monetary policies, including their exit strategies.

Two challenges for CBI in the low-inflation period

The legacy of the great financial crisis of 2008 and the low inflation conditions that have since been observed bring new challenges for CBI. These challenges fall into two categories. First, the independence of central bank instruments has been put into question by external parties. Second, even if the instruments’ independence is not formally challenged, it may be effectively compromised as a result of the altered conditions. The two kinds of challenges are obviously interconnected.

My own verdict after revisiting the topic of CBI, this time with a Eurozone central banker’s hat (my earlier research1 on the subject goes back 20 years), is that any challenge should not be in the very concept of independence, but rather in the current economic policy mix: ultra-loose monetary policy plus tight fiscal policy. Monetary policy obviously interacts with other policies, namely fiscal, structural and financial. Separate authorities charged with the conduct of these policies may be formally independent, they are, however, also interdependent. The risk raised by such interdependence is that if one independent policy authority does not take appropriate action to meet its mandated objectives, the remaining independent authorities may be obliged to over-react in a persistent manner in order to meet their own objectives. To provide an example, a direct way of identifying such a policy interdependence failure is in the field of nominal demand: e.g. in the eurozone, nominal demand in Q2/2016 was only 7% higher than in Q2/2008 (real domestic demand was 1% lower than it had been in the abovementioned periods), but much lower than the potential increase in its trend rate (roughly at 24% cumulatively, assuming a trend rate of real growth of 1% and a target inflation rate of 2%). Compare this number (7%) with the one for the US 23% of nominal demand growth during the same period. In brief, this may result in a regime of “weak dominance” of other policies over monetary policy, effectively destabilising the regime of monetary dominance that CBI is meant to establish. In other words, by keeping interest rates in negative territory for too long, the redistribution effects of monetary policy and the perceived degree of success of meeting the mandated objectives become more pronounced. The independence of central banks may be scrutinised due to concerns as to whether a central bank with an extended mandate of objectives can operate transparently and with an appropriate degree of accountability in the context of a democratic political system. All in all, an independent central bank that is subject to checks and balances and to democratic accountability needs broader support from the public. Clearly, with persistent negative rates one is sooner or later bound to lose major parts of the broad constituency needed by independent central bankers.

In closing, this is clearly an area where views diverge. Some may call it independence, others may view it as autonomy; some may want to think of it as a misnomer, others may view it as something deeper in the end which affects a central bank’s operational independence. However, on the balance of existing theory and empirical evidence, I maintain that an independent central bank focused on price stability, along with structural adjustments, appropriate and sustainable fiscal policies and an enhanced technology ensuring macro-prudential stability offer the most promising path for restoring normal growth conditions and the creation of jobs, which is the ultimate objective.

1Mourmouras, I. (2000), Monetary policy at the European periphery, Springer-Verlag, Berlin-New York, 220 pages. Mourmouras, I. (1995), “Central bank independence, policy reforms and the credibility of public debt stabilisations”, European Journal of Political Economy, pp. 189-204. Mourmouras, I. (1994), Towards granting political and economic independence to the Bank of Greece [in Greek], To Vima, Athens.

*Abridged version of two speeches made in Tokyo at a Japan Centre for Economic Research (JCER) Conference and in Kuala Lumpur at a South East Asian Central Banks Research and Training Centre (SEACEN) Policy Summit in November 2016. For a full version, see at: https://www.bis.org/review/r161223b.pdf.

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