Over the last several decades, central bank independence became the sacred cow of monetary policy. Dissenting murmurs emerged during the 2007 to 2009 recession, when some suggested the U.S. Federal Reserve should focus on jobs, not inflation. Since COVID-19, these murmurs have become prominent points of contention, permitting backtracking on central bank independence.
A new policy consensus emerged, arguing stable, low inflation fosters economic growth. Because politicians might still be tempted to boost short-term economic growth through loose money policies, many argued independent and technocratically managed central banks were necessary to deliver low inflation.
Since the onset of COVID-19, governments are grappling with a renewed debate over whether they can trade inflation for economic growth. Philips curve , the basis of monetary policy in the 1960s and 1970s, suggested high inflation could support economic growth. Starting in the 1970s, this economic mantra fell out of favor as economies began to experience stagflation , the co-occurrence of inflation and low economic growth.
Since the onset of COVID-19, governments are grappling with a renewed debate over whether they can trade inflation for economic growth. Philips curve, the basis of monetary policy in the 1960s and 1970s, suggested high inflation could support economic growth. Starting in the 1970s, this economic mantra fell out of favor as economies began to experience stagflation, the co-occurrence of inflation and low economic growth.
A new policy consensus emerged, arguing stable, low inflation fosters economic growth. Because politicians might still be tempted to boost short-term economic growth through loose money policies, many argued independent and technocratically managed central banks were necessary to deliver low inflation.
Over the last several decades, central bank independence became the sacred cow of monetary policy. Dissenting murmurs emerged during the 2007 to 2009 recession, when some suggested the U.S. Federal Reserve should focus on jobs, not inflation. Since COVID-19, these murmurs have become prominent points of contention, permitting backtracking on central bank independence.
Why? Like any Law & Order episode will reveal, the culprit can only act when provided the means, opportunity, and motive. For some governments, COVID-19 provided the conditions necessary for backtracking.
Unlike previous economic downturns, the COVID-19-induced recession created policy space for unprecedented collaboration between central banks and finance ministries. In the United States, for example, the Coronavirus Aid, Relief, and Economic Security Act established the Paycheck Protection Program, which was initially funded through the Federal Reserve’s use of emergency lending authority. The U.S. government later committed $483 billion to enhance worker retention and soften the economic blow for small-business owners.
In total, the Federal Reserve and U.S. Treasury Department together funded seven emergency liquidity facilities, which entailed the Fed to buy debt, notes, or loans held by other entities, which could then use this cash to support the economy.
Some governments took advantage of blurry lines between government and central bank recovery programs to continue their oversight. In particular, some autocratic leaders saw opportunities to reinterpret central bank mandates: from maintaining low inflation without political interference to promoting economic growth under the guidance of their finance ministries.
In Turkey, central bank independence is now an endangered species. The country’s 2021 inflation rate stands at 36 percent. With a sharply devaluing lira fueling its currency crisis, the Turkish government should want interest rate increases. Contrary to the central bank’s advice though, Turkish President Recep Tayyip Erdogan has successfully demanded interest rate cuts four times since September 2021. His top economic priority is delivering short-term economic growth despite inflationary damage.
Over his nearly 20-year tenure as Turkey’s leader (first as prime minister and then as president), Erdogan has terminated nearly every economic official who disagreed with his economic philosophy. But his central bank meddling accelerated once the pandemic started. In July 2020, Erdogan eliminated a requirement that central bank deputy governors have at least 10 years of experience as practitioners. Removing this requirement permits him to appoint individuals who are not steeped in the central bank’s inflation-fighting and independence-safeguarding culture.
Since March 2020, Erdogan has dismissed two governors over interest rate policy disagreements. Erdogan even wants to prosecute former central bankers on trumped-up criminal charges.
Erdogan is not alone in revoking central bank independence. Chinese President Xi Jinping bluntly asked his country’s central bank to cut the bank’s reserve requirements to reverse China’s economic slowdown fueled by its declining housing market. Be it Chinese businessman Jack Ma or the central bank, no actor dares oppose the Chinese government.
The central bank has meekly complied by decreasing the ratio of deposits that financial intermediaries must hold in reserves. Lowering reserve requirements increases the funding pool available to banks, putting the economy on steroids. But as growth creates inflationary pressures, lower reserve requirements put banks at risk, lest depositors want to withdraw funds. For the Chinese government, economic growth provides legitimacy. Other priorities can wait.
Are democracies backtracking on central bank independence as well? For example, U.S. President Joe Biden could follow Erdogan or Xi’s lead, given Biden’s sagging poll numbers and pressure from “modern monetary theory” advocates for an activist Federal Reserve. And in fact, Biden had the opportunity to move in this direction with the current Fed chair’s term slated to end in February. Yet he decided to renominate Jerome Powell, a Republican holdover from the last administration, over objection from some of his party’s senators. In his announcement renominating Powell, Biden emphasized the need for a nonpartisan independent central bank committed to its mandate.
Why then are autocracies and democracies following different central bank independence paths? The COVID-19 shock has triggered a recession accompanied by inflation. Citizens are tired of economic lockdowns and other disruptions. The short-term horizon of many citizens means government leaders are under pressure to deliver economic growth (and normalcy) quickly.
But rising inflation now puts central banks in an awkward position. Should they continue supporting government COVID-19 recovery efforts through loose money policies, or should they taper the stimulus to address inflation?
This is where the motives of autocracies and democracies diverge. Autocratic governments need to deliver short-term economic growth because they derive legitimacy not through democratic processes but by delivering prosperity (and, sometimes, by invoking nationalism). In China, for example, growth provides legitimacy to the communist regime. Indeed, the party promotes regional leaders when they deliver on economic growth promises.
Arguably, Biden faces similar incentives. Sagging poll numbers and the Democratic candidate’s loss in Virginia gubernatorial elections do not bode well for 2022 midterm elections. And even in U.S. politics, using political consultant James Carville’s famous words, the top campaign issue remains “the economy, stupid!”
What then differentiates Biden from Erdogan or Xi? Ultimately, democracies are rules-based societies. They respect institutional continuity—be it the peaceful transfer of power or central bank independence. Biden understands institutional strength as a useful tool. (The same probably does not hold for former U.S. President Donald Trump.) Moreover, Biden’s bipartisan prestige was probably enhanced when he reappointed Powell despite objections from progressives.
Inflation can become a focal event for citizens unhappy with their regime. Price hikes can trigger street demonstrations, as seen in Kazakhstan’s ongoing protests. The possibility of mass unrest is particularly important for Turkey given Erdogan’s sagging popularity. For China, a major exporting economy, inflation can erode its global competitiveness and eventually hurt its long-term economic growth.
In the months to come, rising inflation might compel Turkey and China to reinstitute central bank independence. Until then, their defections from the central bank independence mantra provide a test of whether governments can manipulate interest rates without penalties for igniting inflation.