Low inflation over long periods is the sign of an effective central bank. The authors suggest that a large fraction of the worldwide decline in inflation since the early 1980s results from an international movement toward more independent central banks.Banks and banking, Central ; Inflation (Finance)

Charles T. Carlstrom

Timothy S. Fuerst

English

Research Papers in Economics

September 1, 2006
Federal Reserve Bank of Cleveland
Central Bank Independence: 
The Key to Price Stability?
by Charles T. Carlstrom and Timothy S. Fuerst
ISSN 0428-1276
Low inflation over long periods is the
sign of an effective central bank. The
authors suggest that a large fraction
of the worldwide decline in inflation
since the early 1980s results from an
international movement toward more
independent central banks.
Industrialized nations have achieved a
remarkable decline in inflation: Their
average annual rate tumbled from 
5.6% in the 1955–88 period to 2.7% in
1988–2000 (see figure 1). One of the
most extraordinary success stories is
New Zealand, whose average annual
inflation plummeted from 7.6% in the
earlier period to 2.7% in the later one.
Many commentators have attributed this
improvement to inflation targeting,
which New Zealand instituted in 1989,
but it would be premature to credit 
inflation targeting alone. 
The turning point was the 1989 passage
of the Reserve Bank of New Zealand
Act, which incorporated two fundamen-
tal reforms: First, it gave the Reserve
Bank greater independence from the
central government.  Second, it estab-
lished an explicit inflation target,
becoming the first of many countries 
to do so.  Once considered the least
independent of central banks, New
Zealand’s now ranks among the more
independent ones.  
This Economic Commentary suggests
that greater independence has been the
key factor in New Zealand’s inflation
success. Furthermore, it was not the only
nation to grant its central bank more
independence. Others followed suit, and
increased independence is, perhaps,
responsible for a decline of nearly two
percentage points in the average infla-
tion rate for the industrialized nations 
as a whole. 
■ Advantages of central bank
independence
The hallmark of good central banking is
maintaining low levels of inflation over
extended periods. But what institutional
structure is most likely to achieve and
preserve low inflation?  Central banks
are considered more independent when
they can resist the pressure to make
short-term policy decisions that are at
odds with their long-term objectives.
Central banks gain independence chiefly
through institutional reforms such as
long-term appointments for central bank
governors, for example; explicit inflation
targets; and a combination of institu-
tional reforms and targeting. The ele-
ment common to both inflation targeting
and central bank independence is con-
straint of the fiscal authority’s behavior.   
At first glance, it is hard to see any 
benefit in imposing constraint on one-
self. But most of us need some sort of
commitment in the face of temptation,
whether it in the form of Ulysses having
himself lashed to the mast to resist the
lure of the sirens, or moving the alarm
clock to the far side of the room to with-
stand the yearning for extra sleep. Such
constraints inhibit people from acting 
in their short-term interest, recognizing
that actions that seem optimal in the
short term may be undesirable in the
long term.
The same is true of the fiscal authority,
which may be tempted to inflate in the
short run to deliver, say, a more favorable
exchange rate, a higher output rate, or a
lower level of inflation-adjusted debt.
These short-run temptations may contra-
vene the goal of long-run price stability,
so it may be in society’s best interest to
grant monetary policy power to an inde-
pendent, far-sighted central bank.  
Because we are interested in the evolu-
tion of independence over time, this
Commentary uses two different studies
of central banks’independence in indus-
trialized nations, one for 1955–1988 and
one for 1988–2000.  Economic growth
has increased the number of industrial-
ized nations, so the later sample is larger
than the earlier one.  To measure inde-
pendence, these two studies consider
several common factors, including the
extent of instrument and/or target inde-
pendence, the central bank’s practices
for financing government debt, the
length of governors’terms, and the rela-
tive importance of inflation stabilization
and output stabilization.  
Governments use various institutional
means to implement independence.  For
example, in the United States, five of the
12 regional reserve bank presidents have
a policy vote at any given time. These
presidents are appointed by the boards
of directors of their respective district
banks. In addition, the seven Federal
Reserve governors are appointed by 
the president of the United States 
(and confirmed by the Senate) to long, 
staggered tenures, a practice that nearly
guarantees a bipartisan commitment.
Neither the U.S. president nor Congress
can remove a governor or district bank
president without cause.     ■ Quantifying inflation 
success
Figure 2 shows that New Zealand’s
independence score rocketed from 
25 in 1955–88 to 89 in 1998–2000,
with passage of the act as a watershed.
In the earlier period, New Zealand
was the least independent central
bank; in the later period, it ranked
among the most independent. And
other nations have granted their cen-
tral banks more independence as 
well; consequently, the developed
countries as a whole have undergone 
a substantial increase in central bank
independence over time. In figure 2,
all of them lie close to or above the 
45 degree line, implying that indepen-
dence is (almost) always greater in 
the more recent period.  
We have noted that New Zealand’s
inflation rate fell from 7.6% (above
the industrialized countries’average)
in the earlier period to 2.7% (below
average) in the later one. How much
of this success can be explained by
the increased independence of their
central bank?  
Figure 3 demonstrates a strong relation-
ship between independence and infla-
tion for a group of countries in the ear-
lier period. In the later period, the
relationship for the same nations is less
clear. Because countries that had little
independence in the early sample greatly
increased it in the later one, the variation
of independence among countries
decreased, which makes drawing conclu-
sions more difficult. However, if we
broaden the sample to include Austria,
Greece, Hong Kong, Iceland, Ireland,
Korea, Portugal, Singapore, Taiwan, and
Finland, figure 3 reveals a strong rela-
tionship between independence and aver-
age inflation. Moreover, the impact of
independence on inflation is similar
across time, a result that is consistent
with other studies.
From the linear pattern in figure 3, we
can deduce that the predicted decline in
New Zealand’s inflation comes solely
from its dramatically increased inde-
pendence, which is responsible for a
decline of 4.2 percentage points in its
average inflation rate. That is, holding
all else equal, if New Zealand in the
earlier time period had an indepen-
dence score as high as today’s, then the
annual inflation rate would have been
3.4% instead of the 7.6% that actually
occurred.  
Referring again to figure 3, we conclude
that holding everything else equal, the
increase in central banks’independence
would have lowered the average infla-
tion rate worldwide from 5.6% to 3.8%.
FIGURE 1 INFLATION
–2
0
2
4
6
8
10
12
14
16
18
20
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Inflation, 12-month percent change
New Zealand
OECD countriesa
a. All OECD countries except Turkey.
SOURCES: International Labour Organization; Organisation for Economic Co-operation and Development; Bloomberg Financial Information 
Services; Alesina and Summers, 1993; and Fry et al., 2000.
10
20
30
40
50
60
70
80
90
100
110
10 20 30 40 50 60 70 80 90 100 110
New Zealand
Independence, 1955–88
Independence, 1988–2000
■ The New Zealand
example
Before 1989, the Reserve Bank of
New Zealand was essentially an arm
of the government and enjoyed little
independence. The Bank was an
advisor to New Zealand’s govern-
ment, so its monetary policy was
subject to the discretion of the minis-
ter of finance.
Figure 2 illustrates this. Historically,
New Zealand ranked lowest among
industrialized countries in measures
of central bank independence, and
its inflation rate was among the
highest. Throughout the 1970s, 
New Zealand posted double-digit
inflation levels, sometimes exceed-
ing 18%. The response was the 
1989 passage of the Reserve Bank 
of New Zealand Act, a monumental
piece of legislation. As the act
defines it, the central bank’s primary
function is to “formulate and imple-
ment monetary policy directed to 
the economic objective of achieving
and maintaining stability in the 
general level of prices.” The act 
codifies inflation targeting and gives
the bank a high degree of autonomy
as to how it meets its objectives. It
also limits severely the circum-
stances under which the bank’s gov-
ernor can be dismissed.  
FIGURE 2 INDEPENDENCE, EARLY PERIOD 
VERSUS LATE PERIODSimilarly, changes in independence
were not responsible for the large
inflation run-up that occurred during
the 1970s in the United States and
throughout the world. Central bank
independence was roughly constant
across countries until the late 1980s.
From then until the early 1990s,
most countries’central banks became
significantly more independent,
partly because of poor inflation 
performance in the 1970s and 1980s. 
■ What about inflation
targeting?
This Commentary does not assess the
importance of inflation targeting. 
But is worth noting that the average
inflation rate since 1990 (when many
central banks adopted explicit tar-
gets) is nearly the same for countries
with targets (2.5%) and without them
(2.9%). This difference is statistically
insignificant, that is, entirely consis-
tent with pure chance. Furthermore,
the average independence level is
nearly the same for both groups of
countries.  
Nonetheless, we should not conclude
that inflation targeting is unimpor-
tant.  For example, could the Reserve
Bank of New Zealand have achieved
as much autonomy had it not
adopted an explicit inflation target?
The same question applies to the
United Kingdom, which adopted an
explicit inflation target in 1992 and
whose independence score afterward
rose from 50 to 77. The country’s
average inflation rate fell by 2.7 per-
centage points, whereas figure 3
would have suggested a decline of
1.8 percentage points. 
Furthermore, as often happens, the
absence of correlation does not 
necessarily mean a lack of causa-
tion. For example, suppose that
nations are more likely to adopt
inflation targeting when they are
experiencing persistently high infla-
tion rates.  In that case, the data will
include countries that have adopted
targeting but still have high inflation
rates. If targeting is effective, these
rates will fall but they may take
more time to do so.  Similarly, coun-
tries that have adopted targeting may
be unique in that it was their only
possible means of controlling infla-
tion.  
■ Conclusion
The evidence given here, which links
central bank independence and long-
run inflation, has clear normative
implications.  An independent central
bank is a government’s most effective
way to ensure delivery of a low infla-
tion rate. Furthermore, nearly 2 per-
centage points of developed countries’
average decline in inflation over time
is the direct results of their central
banks’increased independence. 
It is important to emphasize that 
the results presented here are for
industrialized nations.  There is some
evidence that the link between central
bank independence and long-run infla-
tion is much weaker for developing
nations, but that would not necessarily
mean that independence is unimpor-
tant for them.  It is possible that other
forces that affect their inflation rates
may obscure the beneficial effect of
independence on inflation.  
■ References:
Alesina, Alberto, and Lawrence H.
Summers, “Central Bank Indepen-
dence and Macroeconomic Perfor-
mance,” Journal of Money, Credit,
and Banking 25(2), May 1993, pp.
151–62.
Fry, Maxwell, Deanne Julius, Lavan
Mahadeva, Sandra Roger, and Gabriel
Sterne, “Key Issues in the Choice of
Monetary Policy Framework,” in
Lavan Mahadeva and Gabriel Sterne,
eds, Monetary Policy Frameworks in a
Global Context,  pp. 1–216. Rout-
ledge: London, 2000.
Reserve Bank of New Zealand, 
“Central Banking in New Zealand,”
September 2002.
http://www.rbnz.govt.nz/about/
central_bankingnz.pdf
0
1
2
3
4
5
6
7
8
9
10
10 20 30 40 50 60 70 80 90 100 110
Independence
Average annual inflation, percent
New Zealand
New Zealand
1955–1988a
1988–2000a
1988–2000b
a. For New Zealand, Spain, Italy, Belgium, France, Norway, 
Australia, Sweden, U.K., Denmark, Japan, Netherlands,  Canada, U.S.,
Germany, and Switzerland. 
b. For Austria, Greece, Hong Kong, Iceland, Ireland, Korea, Portugal,
Singapore, Taiwan, and Finland.
SOURCES: International Labour Organization; Organisation for 
Economic Co-operation and Development; Bloomberg Financial 
Information Services; Alesina and Summers, 1993; and Fry et al., 2000. 
FIGURE 3 AVERAGE INFLATION
VERSUS INDEPENDENCE
In fact, worldwide inflation averaged
5.6% in the 1955–88 period and 2.7%
in 1988–2000. (We average inflation
only until 2000, when the ECB was
established, but our results are not sig-
nificantly affected if we treated the
ECB countries as one country from
1988 to 2000.)
Of course, greater independence can-
not explain all of the improvement in
inflation over time. For example,
although the United States’indepen-
dence score changed very little (from
88 in the earlier sample to 92 in the
more recent one), its inflation rate fell
from 4.1% to 3.3%.  This decline of 
80 basis points is evidently not caused
by changes in independence but by
other forces that have lowered the
worldwide inflation rate.  Because the
later sample includes more countries,
comparing the two linear relationships
in figure 3 is problematic. But the gap
between the relationships may reflect
an aggregate drop in inflation of about
65 basis points for reasons other than
independence.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
Charles T. Carlstrom is a senior economic 
advisor at the Federal Reserve Bank of
Cleveland; Timothy S. Fuerst is Owens 
Illinois Professor of Economics at Bowling
Green State University and a research 
associate at the Federal Reserve Bank 
of Cleveland.
The views expressed here are those of the
authors and not necessarily those of the Fed-
eral Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
Research Department of the Federal Reserve
Bank of Cleveland. To receive copies or to be
placed on the mailing list, e-mail your request
to 4d.subscriptions@clev.frb.org or fax it to
216-579-3050. Economic Commentary is also
available at the Cleveland Fed’s site on the
World Wide Web: www.clevelandfed.org/
research.
We invite comments, questions, and sugges-
tions. E-mail us at editor@clev.frb.org.
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Central Bank Independence and Macroeconomic Performance,”

Key Issues in the Choice of Monetary Policy Framework,”

Labour Organization; Organisation for Economic Co-operation and Development; Bloomberg Financial Information Services; Alesina and Summers,

Reserve Bank of New Zealand, “Central Banking in New Zealand,”

Central bank independence: the key to price stability?

http://www.clevelandfed.org/Research/commentary/2006/0901.pdf

Central bank independence: the key to price stability?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics