Independence & Transparency of Central Banks

1. The Evolution of Central Bank Governance
Around the World
By
pvishwarathreddy@gmail.com

2. Trivia
• World’s Oldest Surviving Central Bank – Riksbank (Sweden)
1668; Bank of England -1694.
• Since 1989 (Fall of Soviet Union), 15 Central Banks were
created in Eastern Europe.
• EU created European Central Bank.
• In all these situations Central Bank law was revised or
rewritten.
• Institutional objectives, practices and structures were
amended or created from scratch.

3. About this Article
• Written by Christopher Crowe and Ellen E. Meade.
• Published in Journal of Economic Perspectives – Fall 2007.
• This article surveys and quantifies the trends in two areas of
central bank governance : Independence and Transparency
• It tracks the progress of central banks in these two aspects in
the developing and developed countries for the past 10-15
years  Inflation.
• Third aspect – Committee structure and decision making in
Developed Countries.

4. • Main impetus  widespread inflation during
1970’s.
• Reasons:
– Political pressure to boost the economy & reduce
unemployment.
– Leads to high inflation in the long run.
• Solution: Delegate the responsibility of monetary
policy to individuals who are highly averse to
inflation and insulate them from the rest of
government.
Central Bank Independence

5. Measurement – Cukierman, Webb, Neyapti (1992)
• Measured on four legal characteristics
– Bank’s management is insulated from political
pressure by secure tenure and independent
appointment.
– Government cannot participate in or overturn its
policy decisions.
– Bank’s legal mandate specifies clearly defined
objective for monetary policy.
– Financial Independence: Bank’s ability to restrict
lending to the government.

6. Measurement – Cukierman, Webb, Neyapti (1992)
• Four legal characteristics pertaining to procedures for
appointment or dismissal of the central bank governor,
accounted for 20% of overall index.
• Three legal characteristics used for central bank’s policy
formulation process, accounted for 15% of the overall
index.
• A single characteristic used to judge the central banks’
policy objective accounted for 15% of the overall index.
• Eight characteristics to judge the limitations on central
bank lending to the government, which accounted for
50% of the overall index.

7. Results
• Federal Reserve’s Score – 0.48 (low due to areas of policy formulation and
the monetary policy)
• Federal Reserve Act directs the Fed to achieve both high employment and
price stability  conflicting objectives.
ECB & Riksbank

8. Implications
• A key finding (Alesina and Summers – 1993) – statistically significant
association between greater independence and lower inflation for
industrial countries.
• By reducing the hyperinflationary outliers and regrouping, inverse
relationship was obvious in transition countries of central Europe.
• However this inverse relationship did not hold for industrial
countries.
• Another important aspect which the paper looked into was
turnover of Central bank’s Governor.
• If high turnover , CB Governor’s office in term relative to the
executive is shortened  susceptible to political interference.
• Governments with low inflation did not tinker with central bank’s
governance and countries with higher inflation made their central
bank more independent.

9. Implications - Downsides
• Greater independence  requirement for institutional and
personal accountability. (Eg: Bank of Italy – Antonio Fazio –
Bank merger deal)
• Countries addressed this issue of accountability by limiting
the mandate of the central bank – “Instrument
Independence”
• U.K Government mandates Bank of England with inflation
target of 2%.
• “Goal Independence” : Government gives the central bank a
broad mandate that requires interpretation.
• Federal Reserve Act., tasks the U.S. Central bank with
“maximum employment, stable prices and moderate long
term interest rates.” – Fed must interpret and prioritize these
goals.

10. Central Bank Transparency
• Why?
– Communicating its intentions to the public  ↓ Uncertainty
– Though it influences short term interest rates but for monetary policy to
be effective, they must influence longer rates as well by signaling
movements in future policy and anchoring inflation expectations (∏e).
• Measuring Central Bank Transparency
– Political Transparency: Pertains to clarity of central banks legal mandate.
– Economic Transparency: Refers to publication of economic data, models
and forecasts used by the central bank to arrive at its policy decisions.
– Procedural Transparency: Communication of exclusive policy strategy as
well as information on the decision making process.
– Policy Transparency: includes the timely announcement and explanation
of policy actions and some indication of likely future action.
– Operational Transparency: Discussion of economic disturbances and policy
errors that are likely to affect the transmission of policy.

11. • Transparency Country Sample
• Advanced economies (26)
– Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany,
– Greece, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg,
– Netherlands, New Zealand, Norway, Portugal, Singapore, Spain,
Sweden,
– Switzerland, United Kingdom, United States
• Emerging market and developing economies (14)
– Argentina, Brazil, China, Czech Republic, Hungary, India,
Indonesia, Mexico,
– Poland, Russia, Slovakia, Slovenia, South Africa, Turkey
Central Bank Transparency

13. Central Bank Transparency
Research Results
* European Central Bank remains much lower than the inflation targeting regimes.
It reveals much lesser information.

14. Implications and Changes

15. Drawbacks to Transparency
• Ranking Central Banks based on transparency suggests
that greater transparency is better and it can be
achieved in an identical manner for each bank.
• Rational Behind this thought is that it will reduce
uncertainty through better communication of the
central bank’s goals.
• However transparency can lead to offsetting changes
within the central bank’s decision making process.
• It can indeed increase the uncertainty rather than
reduce it.

16. Organization of Central Bank
Committees and Decision Making
• Virtually every central bank around the world
replaced a single policymaker with a monetary
policy committee.
• Governor of New Zealand Central bank is the
lone policy maker setting the short term
interest rates.
• Experiments suggest that a committee with
five policy makers make better decisions than
sole decision maker.

17. Concluding Remarks
• Discretionary policymaking in the hands of
independent technocrats, rather than
politicians.
• With greater credibility, Central Banks
reassure the financial markets and reduce the
economic cost of political crises.
• Improved communication through use of
internet.