Why is Central Bank independence important?

Today’s post is about something that might sound technical but is actually crucial to the health of any economy: central bank independence. Why do economists care so much about it? And why should you?

Let’s start with the basics. In the US, the Federal Reserve — the country’s central bank — is independent from the political branches of government. That means the President or Congress can’t just tell the Fed to cut interest rates or print money. The Fed makes its own decisions, guided by its dual mandate: maximum employment and stable prices.

But why not let elected officials have the final say? After all, they represent the people. Shouldn’t they control monetary policy too?

Here’s the problem: politics and good economic management don’t always go hand in hand.

Imagine a government facing an election. There’s a strong temptation to boost the economy by pressuring the central bank to lower interest rates. That might create a temporary economic benefit but can also lead to runaway inflation and long-term instability.

This isn’t just hypothetical. Countries with politically controlled central banks often struggle with inflation. Politicians want short-term gains. But monetary policy needs to be forward-looking.

Sometimes, the best choice for the economy is also an unpopular one. Independent central banks are in a much better position to make those tough calls. They can raise rates when inflation is rising, even if it slows growth in the short run. They can resist printing money to finance government deficits, which helps keep inflation expectations anchored. And most importantly, they have credibility.

If people believe the central bank will act to control inflation, then inflation is less likely to spiral in the first place. If people believe politicians will lower interest rates unnecessarily, high inflation can become a self-fulfilling prophecy.

To be clear, central bank independence doesn’t mean no oversight. The Fed is accountable to Congress. It regularly testifies, explains its actions, and faces scrutiny. But that’s different from being subject to day-to-day political pressure.

There’s a broad consensus among economists that an independent central bank is a key ingredient in a well-functioning economy. It’s one of the reasons inflation in high-income democracies has been relatively low and stable over the past few decades.

Originally published at https://mytwocentsandcounting.substack.com.