Chapter 2 - Central bank independence

Background

2.1        It is now part of the economic canon that central bank independence is desirable to achieve low inflation and maximise longer run economic growth.[1]

2.2         The explanatory memorandum for the bill refers to central bank independence as being 'regarded as international best practice'. This was supported in evidence to the inquiry. For example, Professor Sinclair Davidson, representing the Institute of Public Affairs, stated:

Broadly speaking, the economic literature is in agreement or shows a consensus that central banks that are more independent are more likely to be associated with low levels of inflation.[2]

2.3        Then Reserve Bank Governor Bernie Fraser put it this way in a 1996 speech:

The usual argument for an independent central bank is that governments and politicians cannot be trusted to do the right thing with interest rates. They are assumed to be driven by the electoral cycle, and prone to manipulate monetary policy for short-term political gains...The corollary of this argument is that an independent, expert body not bound up in the electoral cycle would do a better job than politicians in conducting monetary policy. This seems to me to be the strongest reason for entrusting responsibility for monetary policy to an independent central bank.[3]

2.4        Economist Saul Eslake explained how more independent central banks may lead to lower inflation:

...inflation expectations are...informed by people’s understanding of how economic policy will react to a rise in inflation. If it is widely believed that those responsible for economic policy are unwilling to take firm action in response to an acceleration in inflation, or that they will be unable to sustain that action in the face of an adverse public reaction to slowing economic growth and rising unemployment, or that they will postpone a response because of an imminent election, then people will expect inflation to accelerate and hence will seek to take actions to protect themselves against it – actions which will make a further rise in inflation more likely.[4]

2.5        He continued:

As the significance of inflation expectations to the inflationary process became more widely recognized and understood among economists, the importance of policy credibility to influencing inflation expectations gained more recognition. ‘Policy credibility’ means the belief that those responsible for formulating and implementing economic policy have both the intention and the ability to achieve their stated policy objectives, even if it entails some political or other costs. In the context of monetary policy, ‘policy credibility’ has come to be associated with central bank independence – that is, the ability of central banks to set monetary policy without any requirement to seek approval or permission from elected officials for their proposed course of action. [5]

2.6        If the central bank is perceived as independent, financial markets, businesses and employers and employees are less likely to revise up medium-term inflationary expectations when there is inflationary shock to the economy such as a jump in petrol or food prices. This means that the central bank does not have to keep interest rates as high or for as long to return inflation to its target band.

2.7        Associate Professor Steve Keen is less impressed by the performance of independent central banks. While they have performed well on keeping inflation low, he argues they have not maintained the stability of the financial system.[6]

Empirical studies of the impact of central bank independence

2.8        There is now an extensive body of econometric research on this topic. The majority of studies conclude central bank independence is associated with lower inflation.[7] This does not in itself prove that central bank independence causes low inflation. It could be that countries with a particular aversion to inflation would tend to have both independent central banks and low inflation and the correlation between the two overstates the degree of causality from central bank independence to inflation.[8]

2.9        These studies involve quantifying the degree of central bank independence. For example, a study by some International Monetary Fund economists shows that, in terms of institutional autonomy, the RBA scores as 'independent' on only two out of eight criteria, ahead of only Japan and Korea, whereas the European Central Bank scores a full eight and the central banks of Sweden and Switzerland seven.[9]  

2.10        A similar study by Princeton University academics showed that in an examination of legal indicators of independence, Australia's score varies depending on the indicators used.[10]

Overseas practice in appointment and dismissal of governors

2.11        A variety of practices is evident in a study of the appointment of the governors of 98 central banks worldwide, although as shown in Chart 1 the most common procedure is appointment by the head of state (although for some countries this is also the head of government).

Chart 1 – Party who nominates or appoints [11]

2.12        Similarly, a study of the dismissal of central bank governors showed that this is most commonly done by the head of state (Chart 2).

Chart 2 – Party who dismisses [12]

The grounds for dismissal of governors of central banks also vary. (Chart 3)

Chart 3 – Grounds for dismissal [13]

The reality and perception of central bank independence

2.13        Even when the central bank is effectively independent, the perception of independence may be easily damaged. A famous example was the effect of then Treasurer Paul Keating's 'Placido Domingo' speech of December 1990. Speaking at a supposedly off-the-record function, the day after the death of his Treasury Secretary and friend Chris Higgins, an emotional Keating said:

‘I have Treasury in my pocket, the Reserve Bank in my pocket, wages policy in my pocket, the financial community both here and overseas in my pocket’.[14]

2.14        No-one present thought that Keating literally had the global financial community under his complete control. But the phrase about the Reserve Bank was lifted out of context. As then Reserve Bank Governor Bernie Fraser commented about the phrase:

I believe Mr Keating regretted being associated with those throwaway lines and, to my knowledge, he never repeated them. On more than one occasion, he complained that the Bank had acted in ways which were contrary to his own preferences – clear enough evidence, I would have thought, that the Bank was not in his pocket. I also have denied that the alleged ‘in the pocket’ jibe was ever an accurate description of the relationship between the Treasurer and the Reserve Bank, as did my predecessor, Bob Johnston. The original quip was unfortunate enough, but its repetition ad nauseam, in the face of all the denials, was even worse in my view; it certainly did nothing to enhance the Bank’s standing in financial centres around the world.[15]

2.15        Almost two decades later, the phrase is still trotted out.[16] It is this difficulty in maintaining a reputation for independence that leads to attempts to convince outside observers of the central bank's independence by grounding it in legislation.

Cross-party support for central bank independence

2.16        An independent Reserve Bank has cross-party political support in Australia. Both the current and previous Treasurers have signed agreements with the Reserve Bank Governor publicly expressing their 'common understanding...on key aspects of Australia’s monetary policy framework'. It includes a commitment by the Government which 'recognises the independence of the Reserve Bank and its responsibility for monetary policy matters'.[17]

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