Political interference poses a threat to central banks’ inflation struggles

Editor’s note: This article, distributed by The Associated Press, was originally published on The Conversation website. The Conversation is an independent, nonprofit source of news, analysis and commentary from academic experts.

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Almost every country in the world has a central bank – the public institution that manages the country’s currency and monetary policy. And these banks have extraordinary power. By controlling the flow of money and credit within a country, they can influence economic growth, inflation, employment and financial stability – all of which, if played correctly, can provide politicians with an economic boost come election time, only to burden the economy with problems further down the line.

Therefore, recently central banks around the world have been given considerable freedom to set interest rates independently and free from the electoral wishes of politicians.

In fact, data-driven and technocratic – rather than politically motivated – monetary policymaking has been seen as the gold standard for national financial management since the early 1990s. In fact, this solution – in which central bankers keep politicians at bay – achieved its main goal: inflation was relatively low and stable in countries with independent central banks, such as Switzerland and Sweden – certainly until the pandemic and war in Europe began to raise prices all over the world.

By comparison, countries such as Lebanon and Egypt, where independence was never extended, and Argentina and Turkey, where it was limited, have experienced more bouts of high inflation.

However, while independence is seen as effective, central banks have come under increased pressure from politicians over the past decade. They hope to keep interest rates low and gain voters’ gratitude for a humming economy and cheap loans.

Donald Trump is one recent example. While president, Trump criticized his own choice to lead the US Federal Reserve and demanded lower interest rates. Now, if Trump returns to the White House, some of his allies have drawn up plans for an elected Trump to attend Fed rate-setting meetings or at least replace current Fed Chairman Jerome Powell.

Similarly, the independence of the Bank of England was formally reviewed. The British government also put public pressure on the Bank of England to cut interest rates, presumably to shore up the economy ahead of the July general election.

As political economists, we are not surprised when politicians try to influence central banks. Monetary policy, even after independence, has always been political. First, central banks remain part of the government bureaucracy, and the independence granted to them can always be withdrawn – either by changing the law or by withdrawing from established practices.

Moreover, the reason why politicians – especially those facing elections – may want to interfere with monetary policy is that low interest rates remain an effective and quick way to stimulate the economy. And while politicians realize there are costs to putting an independent central bank under siege – financial markets could react negatively or inflation could spike – short-term control over a powerful policy tool may prove irresistible.

Legislative independence

If monetary policy is such a desirable policy tool, how have central banks reined in politicians and maintained their independence? Is this independence being eroded?

Generally speaking, central banks are protected by laws that give their leaders long terms, allow them to focus policy primarily on inflation, and severely limit lending to the rest of the government.

Of course, such legislation cannot predict all future events that may open the way to political interference or law-breaking practices. Sometimes central bankers are unceremoniously fired.

But regulations keep politicians in check. For example, even in authoritarian countries, laws protecting central banks from political interference have helped reduce inflation and limited central bank lending to the government.

In our own research, we have discussed in detail how regulations have isolated central banks from the rest of government, but also the recent trend towards limiting this legal independence.

Politicization of nominations

Around the world, appointments to central bank leadership positions are political – elected politicians choose candidates based on professional credentials, political affiliations and, importantly, their aversion to or tolerance of inflation.

However, lawmakers in different countries exercise different degrees of political control.

The 2023 study shows that the vast majority of central bank leaders – approximately 70% – are appointed by the head of government alone or with the participation of other members of the executive branch. This ensures that the preferences of the central bank come closer to those of the government, which may increase the legitimacy of the central bank in democratic countries, but carries the risk of permeability of political influence.

Alternatively, appointments may include the legislature or even the central bank’s own board. In the US, while the president nominates members of the Federal Reserve Board, the Senate can and has rejected unconventional or incompetent nominees.

Moreover, even when appointments are political, many central bankers remain in office long after their appointers are voted out. By the end of 2023, the most common term for governors was five years, and in 41 countries the legal term was six years or longer.

In the 2000s, several countries reduced the terms of office of their central bank governors to four or five years. Sometimes this was part of broader restrictions on central bank independence, as happened in Iceland in 2001, Ghana in 2002 and Romania in 2004.

Low inflation target

From 2023, the main goal of all but six central banks in the world was low inflation. However, many central banks are legally obligated to try to achieve additional, sometimes conflicting goals, such as financial stability, full employment, and support for government policies.

This is the case of 38 central banks that either have a clear dual mandate on price stability and employment or have more complex goals. In Argentina, for example, the central bank’s mandate is to ensure “employment and economic development combined with social equality.”

Conflicting goals may expose central banks to politicization. In the US, the Federal Reserve has a dual mandate of stable prices and as sustainable employment as possible. These goals are often complementary, and economists argue that low inflation is a prerequisite for sustained high levels of employment.

However, in times of overlap between high inflation and high unemployment, as in the late 1970s or as the Covid-19 crisis winds down in 2022, the Fed’s dual mandate has become an active area of ​​policy contention.

Since 2000, at least 23 countries have expanded the focus of their central banks beyond just inflation.

Government borrowing limits

The first central banks were created to help secure financing for governments fighting wars. However, currently, limiting lending to governments is the basis for protecting price stability against unsustainable fiscal spending.

History is littered with the consequences of failing to do so. For example, in the 1960s and 1970s, central banks in Latin America printed money to support their governments’ spending goals. However, this caused massive inflation while providing neither growth nor political stability.

Currently, lending restrictions are strongly linked to lower inflation in developing countries. In contrast, central banks with a high degree of independence can reject government funding requests or dictate loan terms.

However, over the past two decades, almost 40 countries have reduced the ability of their central banks to limit central government funding. In more extreme examples – such as Belarus, Ecuador and even New Zealand – they turned the central bank into a potential government financier.

Scapegoats of central bankers

In recent years, governments have tried to influence central banks by pushing for lower interest rates, issuing statements criticizing banking policies or calling for meetings with central bank management.

At the same time, politicians blamed these same central bankers for a number of perceived failures: failing to anticipate economic shocks such as the 2007–2009 financial crisis; overstepping its powers through quantitative easing; and creating massive inequality and instability while trying to save the financial sector.

Since mid-2021, major central banks have been trying hard to keep inflation low, raising questions from populist and anti-democratic politicians about the merits of an arm’s length relationship.

However, limiting central bank independence is historically a sure path to high inflation.

Cristina Bodea is a professor of political science at Michigan State University.

Ana Carolina Garriga is Professor of Political Science at the University of Essex.