Limits of central bank independence


Before 1970, there was little talk of central bank independence, mainly because inflation was not much of an issue, and the level of financialisation in general was on the lower side; especially all the more in developing countries like Pakistan.

However, since the oil crisis of 1973– when at the back of Mideast tensions, the oil price jumped from $2 to $11 a barrel in a few weeks- the issue of inflation came centre-stage, and with it the role of central banks. Over time, central banks generally started to gain greater independence, to allow them in turn larger control in setting the price of capital– or policy rate– and in curtailing the role of government through moving towards brands of flexible rate regimes, especially after the end of the Bretton-Woods system by 1973.

Since then, and till the global financial crisis of 2008, remained the time of so-called ‘Great Moderation’ in which price stability was mainly targeted as declared or un-declared target in countries, under a more powerful central bank; ‘so-called’ because structural weaknesses in the economy were air-brushed through evolving fancy but risky financial instruments, and by placing little focus on institutional and governance reforms on the aggregate supply side, especially labour-market reforms. A greater central bank role also meant that often they were unable to keep up with their primary role before that of coming up with better macro-prudential surveillance and incentive policies.

The rise of Neoliberalism in economic policy during the same time, meant that the role of government started to recede at the back of mainstream economics thought process– taught in leading economics faculties of the world– and technical input received through policy prescription of donor agencies like International Monetary Fund (IMF) and the World Bank, and from foreign-educated national economic advisors/finance ministers evolving policy with a similar mindset.

In time, governments apparently handed over a lot of control to the respective central banks to achieve macroeconomic stability. Here, monetary policy was seen as a panacea for dealing with macroeconomic issues, while growth was reduced only as a residual concern; left primarily to the markets with little intervention. Eventually, this neoliberal thought process resulted in lack of attention on fixing structural and institutional issues and providing adequate market regulation, especially needed greater macro-prudential policy intervention for imparting better oversight and sense of responsibility to the financial sector.

This resulted in a lot more financial crises from when compared to the time before the 1970s and the start of the Bretton-Woods system. At the same time, sustained macroeconomic stability could not be achieved. In developing countries, the havoc was far more, as the wave of Neoliberalism penetrated deeply under both programmes with IMF, and independently through a similar mindset by policymakers.

Hence, the developed world did see some price stability, but at the cost of great widening of inequality and structural issues compounding, the developing countries, in general, including Pakistan, neither achieved any semblance of price stability nor sustainably controlled inflation; and also fared badly in terms of inequality and poverty.

Yet, the march of central bank independence continued, even when it became quite clear over time that inflation in developing countries was at least equally a fiscal phenomenon, and that the focus of policy required a balanced approach– both in terms of monetary and fiscal dimensions, and aggregate demand and supply sides. The current programme with the IMF also continues to push the agenda of greater State Bank independence of State (or central) Bank of Pakistan- a bill to be passed in this direction by the end of the current calendar year, being one of the conditionalities of the programme.

This is quite alarming, since historical data of policy rate and inflation indicates, especially since the beginning of 2018, a lack of negative correlation between these two variables. Yet policy rate has been chosen as one of the two main instruments to achieve macroeconomic stability; the other being determination of exchange rate primarily on market principles.

Hence, price stability has been identified as the main goal of macroeconomic policy under the programme, and the central bank has been primarily tasked with it. That leaves little space in the programme to be any more neoliberal, which is unfortunate given how poorly this framework has performed for many countries; both developing and developed. In other words, economic growth has been relegated, primarily as an outcome dependent on achieving price stability first.

This is utterly strange in a country where monetary policy has not and cannot deliver a lot on curtailing inflation because by rising interest rates- the most by an Asian country for over a year now, and which recently was raised by one percentage point in one go to 13.25 per cent- the aggregate demand is continued to be squeezed, while inflation as clearly seen in the basket of goods and service for which CPI (consumer price index) is measured, and which is more a result of governance related interventions to address market failure and underlying transaction costs, and is basically a lot more influenced by cost-push determinants of inflation on the aggregate supply-side.

By signing-up to this programme, the government has allowed itself to be removed from the driving seat, which as the above indicates is a wrong policy option given the aggregate supply nature of inflation, and therefore the limited role of austerity measures in dealing with it. This will only perpetuate the already significantly present phenomenon of stagflation- under which inflation and unemployment rise in parallel, along with a reduction in economic growth.

On the contrary, the central bank’s independence should be curtailed; the government should have an active say in determining policy rate, along with some role at least in how much the state bank should intervene in manage-floating the exchange rate. This would not be a novel demand to make since governments in Turkey and United States for example have recently pushed their respective central banks to provide greater say to governments in their policies; not to mention the support for this in academic literature, especially since the global financial crisis of 2008. This is all the more important, since the exchange rate pass-through on inflation is quite substantial in Pakistan as it is a net-importer of oil, and imports in general are quite high as inputs in domestic production.

Hence, overall the independence of central bank should be reduced in Pakistan. The main focus of the central bank should be towards evolving better macro-prudential policies, so that private sector lending could be spurred in a better way, among areas of intervention in this regard. Limiting the role of central bank is also important for reducing the disenfranchisement of electorate in policy, and in allowing public representatives to take greater responsibility, and in turn face higher level of accountability. Government should not hide behind the central bank- as it appears to be doing- and should take back on its plate what is necessary to deliver on sustainable and equitable growth.