6 What does independence mean to central banks? 6.1 Introduction Central banks have for many years held forthright views on their independence. As Jong ago as 1929, Montagu Norman, Governor of the Bank of England wrote that: | look upon the Bank as having the unique right to offer advice and to press such advice even to the point of nagging; but always of course subject to the supreme authority of the government.’ ‘The tables have turned since Governor Norman's day to the point where it is governments that often hesitate before nagging central banks in public, in case this undermines the credibility of the framework. Various studies have constructed and assessed detailed measures of central bank independence’ and others have criticised them for being subjective.’ This chapter attempts to use subjectivity to its advantage by asking central banker respondents for their impressions about central bank independence using two approaches. The first approach interprets responses to the general, subjective question, How would you define central bank independence? As far as we know, this simple approach has not been used before, yet it reveals which aspects of independence really matter to central banks. The second method involves asking central bankers how independent their own institution’s are, and using the answers to construct an index of self-assessment of independence. We then attempt to explain which objective indicators of central bank independence explain the subjective self-assessment using ordered probit regressions. 6.2 A direct method of understanding what independence means to central bankers Chart 6.1 summarises responses to the question, How would you define central bank independence? We translated the general responses into the110 Key issues in the choice of monetary policy framework categories shown in the chart, which is ordered with categories representing goal independence on the left, instrument independence in the centre, and ther aspects that may affect policy setting on the right-hand side. We used 60 responses! with each country represented in at least one and, as it turned out, at most of seven categories. It is evident from the data underlying the chart that most responses reflect each country’s own experience, and it is under this premise that we interpret the responses. By far the most important factor by which most central banks define independence is the capacity to set instruments and operating procedures; 80% of central banks across a broad range of economies mentioned this in their responses (see Chart 6.1).' In practice the effectiveness of formal arrangements providing central banks with instrument independence may, however, be undermined by a number of factors that are represen- ted by bars towards the right-hand side of the graph. These include the capacity of governments to: (i) be represented on central bank boards; (ii) borrow from central banks; (iii) exert general pressure on central banks; and (iv) exert influence on the staffing of central banks. The absence of fiscal dominance remains a defining characteristic of central bank independence in developing economies (Fry, 1998 and Box 6.A). Dr Courtney Blackman, former Governor, Central Bank of Barbados, is among those who stress that rules on deficit finance are particularly important in developing countries where financial markets are not fully developed and cannot punish government attempts to extract excessive seigniorage revenues.” Extensive recent academic literature, prompted in part by Walsh (1995), has stressed the difference between goal and instrument independence. Almost all central banks considered instrument independence to be an important aspect of independence. By contrast, goal independence tends to be important to central banks in particular circumstances. Chart 6.1 shows that in their identification of the defining factors of independence only 22% of respondents mentioned the ability to set targets, objectives or goals, while 38% defined independence by stressing the importance of legal objectives. The relative importance of these two measures of goal independence depends, as usual, upon circumstances, Central banks are likely to feel more independent when they are able to act to meet clearly defined statutory objectives. The 38% of respondents who defined independence by relating it to the central bank’s statutory objectives’ generally fall into two categories. First, they are central banks whose mandate and statutory objectives have been revised in recent years, such as recently formed central banks in transitional economies and Euro- pean central banks affected by the Maastricht Treaty and other EU legis lation. These responses suggest that governments and central banks are more likely to focus upon legal objectives when these objectives are fresh and pertinent, having been recently debated. ‘The second group that are more likely to define independence according to statutory objectives areWhat does independence mean to central banks? 111 ‘Occasions mentioned as percentage of total responses c trerumentapotcy 20 exatenco inplratavovkinert of goals 30} statory theca! 70} seen sty to 60} faa femelate $f ea Abate poly Indepenerce — Specto nso on 7 sae tomponca Sore 2 oo So 20 ey ost toanc ‘0 ° Lo) Factors mentioned by central bankers as important inthe definition of independence “The responses are the authors’ categorisation of answers tothe question How would you define corival bank independence?’ There were 60 usable responses (23 from indust- alsed economies and 37 tram developing and transitional economies). Respondent cited {an average of 2.9 catagories in industrialised economies and 22 in developing and transi- tional economies. Chart 6.1 Hlow central bankers define independence” central banks in money and exchange rate targeting countries. Money and exchange rates are generally referred to as ‘intermediate’ targets, and as such are likely to complement statutory objectives that focus on the final goal of price stability In contrast, the country groups that did not mention statutory objectives ‘comprised, first, inflation-targeting central banks, where the explicit infla- tion targets are often used to convey directly the message in statutory objectives and second, developing countries, whose statutory objectives ‘more frequently do not defend them from either deficit finance obligations or general government intervention in monetary policy. Which central banks define independence according to the capacity to set their own targets or objectives? They are predominantly central banks that use a domestic nominal anchor, and six of the eleven responses for this definition came from central banks that have used explicit inflation targets recently as part of a disinflation process. As argued in Chapter 3, the responsibilty to set inflation targets may be of heightened importance during disinflation. This is illustrated vividly by one such respondent who posed the rhetorical question, What good is instrument independence if the Parliament or Cabinet sets politically motivated goals that are binding? The responses from inflation-targeting central banks reflect how the rela- tionship between government and central bank is strongly influenced by whether or not inflation is already acceptably low. Central banks in infla- tion-targeting countries with low inflation did not generally regard the ability to set the target as important in assessing their own independence. ‘This suggests that when inflation is low, there is litle scope for disagreement112 Key issues in the choice of monetary policy framework about what the target should be. Indeed, three inflation-targeting central banks in low-inflation economies stated explicitly that independence could be defined in terms of the central bank’s capacity to meet a mutually agreed target. Such responses may reflect how successfully the responsibility for monetary policy has been shared between government and the central bank, ‘The arrangements may not only allow government to control the long-run direction of policy, but they can also help to remove any incentive for the ‘government to create surprise inflation (Goodhart, this volume). If govern- ment attempts to boost output in the short run and forces a target revision against its central bank's published advice, the blatant transparency of such an act is likely to remove the surprise from ‘surprise inflation’. This in turn may reduce any output effects and make such a policy ineffective, In contrast, other responses illustrate that when inflation is high, it has proved to be more difficult for government and the central bank to split responsibilities for inflation targeting and instruments. In the context of ‘Walsh-type models, this may be because in the presence of a high degree of shocks, the temptation may be to revise the contract ex post, thus negat- ing the contract’s benefits. What should happen, for example, if inflation falls below the annual target, but remains above the long-run target for inflation (as happened in 1998 in the Czech Republic, Israel, Poland, and, to a lesser extent, Chile)? The optimal response may depend upon the source of the shock that caused the inflation target to be missed, and in some circumstances an option might be to permit inflation to fall below its short-run target, so that it ean reach its long-run target quicker." In high- inflation countries this policy dilemma highlights the difficulties in specity- ing narrow central bank objectives that provide the basis for an accountable contract between the central bank and government.” In 80% of countries where the monetary policy framework is based on aan exchange rate target, government has a role in setting the exchange- rate target (see Chapter 3), yet the lack of freedom to set an exchange-rate target does not appear to influence how a central bank defines independ- ence. A number of exchange rate and money-targeting countries also describe independence as the capacity to formulate monetary policy. Our interpretation of ‘formulate’ is that it is a ‘catch-all’ term that could refer to goals and instruments, depending upon the circumstances in which it is used, therefore we do not infer any particular significance from these 6.3 An indirect approach to explaining central bank perceptions of their independence ‘The second approach to gauging what independence means to central banks involves using more objective!’ measures of independence to explain responses to the subjective question, “To what extent can your central bank formulate and implement policy without the constraint ofWhat does independence mean 10 central banks? 113 government?” The details of all questions are shown in Table 44 in Chapter 4. The objective measures of independence include the extent to which statutory objectives focus clearly on price stability, the capacity of central banks to define explicit targets independently, the degree of instru- ment independence, freedom from obligatory finance of the government deficit and the length of the Governor's appointment. We use regression analysis to determine which of these best explains the self-assessment of independence. ‘Table 6.1 shows simple correlations between the measures of independ ence. The top row also shows the extent to which the central banks" self- assessment of their independence can be related to each of the objective measures of independence. Self-assessment of independence is strongly associated both with the degree of measured instrument independence and the absence of any deficit finance obligation, In contrast, the extent to which statutory objectives focus on price stability, and the capacity to set targets are each only weakly correlated with self-assessments of independ- ence. In Table 6.1, the only measures of independence that appear to be cor- related significantly with inflation rates in the previous two years are freedom trom deficit finance obligation and the self-assessment of independence. These results, however, are influenced by the endogeneity of each of the variables. It could be that the high inflation has led to high (and increased) independence in some economies. ‘The results from the simple correlation matrix are corroborated in regressions of the perception of independence in the other measures, as shown in Table 6.2. We present results for all countries and for develop- ing, transitional, and industrialised economies. In each case, our ability to explain central banks’ assessments of their independence vary is reason- ably good. For the entire sample of countries, the results confirm that central banks’ self-assessment of independence is fairly well explained by the degree of instrument independence and the limits on deficit finance. The capacity to set targets and the nature of statutory objectives, though cor- rectly signed, are both insignificant at the 10% level. The regressions vividly illustrate differences between different types of economies, The results for developing countries are similar to those of the entire sample ~ the absence of deficit finance and instrument independence explains the self-assessment variable. When we group together developing and tran: tional economies, the results show that limits on deficit finance are the ‘most important influence on the perception of independence. For industrialised economies, variables are less significant, which prob- ably reflects insufficient variance in the regressors. Almost all industri- alised economies have been granted a large degree of instrument independence and do not finance fiscal deficits, and so the variation in the regressors is too small to produce positive results, The term of office of theTable 6.1 Correlations between measures of independence : = é & Ff 4, i » 2 #¢ FF E F é i . B eee Seen au E : feo 22 oe: ois S 5 5 23 gg feo: = & 4 Se Ss 8F G8 Settassessment 100% 10% ot w% «ISK 16H 14% ‘Target setting capaci 10% 0% 0TH HO La Instrument independence asm 9a M% MISS. “Absence of deficit nance sow 10% "Soe bome SBT Statutory objectives 0% 1% se wee Long term office of Govemor 25% 7% 22% Be "2% oe 10% 6 Notes: high score indicates greater independence ‘A coaliient of 0.17 i significant atthe 9% confidence eve: a cocticent of 020i significant at the 95% levelTable 6.2 Regressions of central bank selt-assessments of independence on tangible measures of independence Dependent variable is self assessment of independence Country type Degree of Target Instrument Deficit Term of Observations. Che Preudo-R°' stator seting independence finance office of (prob) independence capactty independence Governor ‘All countres 6 O07) 108%% (OMI) “207 9H) LT GORE) SH “413 (0000) 065 Developing 135e** (0.010) L.70** (0.014) 1455 (0001) 0.13 Transitional 2208 (0.030) 3 486(0291) 00087 Industriatised 1.899 (0.026) 2.21 (0.052)"_ 28 95 (0008) 0.182 Notes: Using an ordered probit regression, “Indicates significance atthe 10% level, “Significant at $3, ***Sigifcant at 1% Probability values in brackets indicate at what lee! of sigalicance the statistic would be no diferen! rom zero, We use an ordered probit method, and for such a technique, a pseudo-R' inthe region of 0.1 is satisfactory. The Chi? ‘overall explanation ofthe regression and is highly significant in ll cases (Mada, 1997) lalsic provides 2 test of the116 Key issues in the choice of monetary policy framework Governor and the capacity to set targets are the only significant variables in this regression, 6.4 Independence and rules versus discretion Is it possible to go on to argue that independence in terms of limited deficit financing obligations is a necessary condition for a central bank to operate a flexible monetary policy strategy (such as the money and infla- tion targeting discussed in Chapter 3 or the mixed strategies discussed in Chapter 5)? Without independence from financing the government, is a rigid commitment to an exchange rate target or an IMF programme the most feasible option to achieve economic stability? Quispe and Mahadeva (this volume) provide the example of Peru in the 1990s to suggest that limits on deficit finance are a precondition for a flex- ible monetary policy. The Central Bank of Peru has reduced inflation through a mixed strategy of using base money growth as an intermediate target, publishing an inflation target as a transparency device, and using as instruments CD (certificate of deposit) interest rate and foreign exchange market interventions. Although Quispe explains how this strategy is sue- cesslul in a heavily asset-dollarised Peru, he points out that this success is contingent on the strict limits that had been placed on the government's ability to require deficit finance from domestie banks, foreign banks, or the central bank. Without these budgetary controls, however, other forms of independ- ence may grant some success to a flexible monetary policy strategy. Box 6.4 explains how a central bank acting independently can reduce credit to the private sector as a response to high public-sector financing demands. In the event that the central bank does not have the variety of policy choices provided by independence, it may yet be able t0 have an independent voice with which to place public pressure on the government to limit future fiscal dominance, Chart 6.1 illustrates that a minority of central banks view independent communication as a defining factor in overall independence. With free communication, the central bank may be able to identify and publish how much of undesirable inflation is due to the finance of the deficit, increasing the possibility that government is seen as responsible for any inflationary pressure it has created. 6.5 Conclusions ‘This analysis of the survey results leads to three main conclusions: i Central banks define independence as an absence of factors that con- strain their ability to set instruments in pursuit of objectives. ults throw interesting light on ‘goal independence’. The ability argets independently of the government was not generally con-What does independence mean to central banks? 117 sidered to be important in countries targeting inflation in low-inflation economies. For disinflating countries, however, it has proved harder to devise clear ‘instrument-independent” relationships between central bank and government based on inflation targets, in which government sets a clear target and the central bank sets instruments to meet the target. iii Finally, the results shed some light on the capacity of measures of independence to explain performance. Posen (1998) is among those to have pointed out that cross-country measures of independence are not always good indicators of performance, Our results provide some reasons why. The factors that affect perceived central bank independ- ence are highly diverse. They include laws, instruments, targets, and government deficit finance. And the relative importance of each of these factors may vary markedly across countries, time, and circumstances. Box 6A Fiscal dominance and central bank independence in developing countries | In many developing countries, monetary policy has been dominated | by fiscal exigencies. There are four primary ways in which govern- [mons can fiance their dicts | 1. Monetising the deficit by borrowing at zero cost from the central bank. 2 Borrowing at below-market interest rates by thrusting debt down the throats of captive buyers, primarily commercial banks. | 3. Borrowing abroad in foreign currency. 4 Borrowing at market interest rates from voluntary domestic | pivot sete loners | The typical OECD country finances about 50% of its deficit from voluntary non-bank domestic sources, while the typical developing country finances only about 8% of its deficit from this source (Fry, 1097, Ch, 1), Evidence suggests that the more a government uses the country’s financial system to finance its deficit, the less independent will be the central bank. The fiscal dominance hypothesis holds that both the magnitude of the government's deficit and the methods by | which it is financed determine central bank independence.” Greater | reliance on the inflation tax and financial repression are associated with less central bank independence, while greater recourse to vol- untary domestic financial markets is associated with greater central | bank independence. ‘There exists one type of freedom or independence in their balance sheets that all central banks may exploit, at least to some extent. To pursue a monetary target, the central bank in any open economy118. Key issues in the choice of monetary policy framework operates to control domestic credit expansion, Hence, if the govern- ment's demands would otherwise produce inflationary domestic credit expansion, the central bank could reaet by reducing credit to the private sector. A central bank that turns to the government and says, “While we can’t resist your financing demands, we will neutralise them by squeezing the private sector and we will tell the private sector exactly why we have to squeeze credit’ is surely acting more independently than one that simply lets domestic credit rise by the full extent of any extra government borrowing from the banking system."" If the central bank behaves consistently in this way by punishing the government through the lobby for private-sector credit, it may exert indirect pressure on the government to reduce its deficit or to finance it in Jess inflationary ways. The measure of central bank independence used in Fry (1998) is the central bank's reaction to increased credit demands by the central government. The monetary policy reaction function is speci fied in terms of the change in domestic eredit scaled by GDP. the intermediate target of monetary policy in most open economies. Among various explanatory variables is the change in net domestic credit to the government scaled by GDP. A complete neutralisation of the government's extra borrowing requirements would imply a coefficient of zero for this variable in this monetary policy reaction funetion. Partial neutralisation would produce a coefficient greater than zero but less than 1. This neutralisation coefficient is interpreted as a measure of central bank independence. In fact, the estimated monetary policy reaction functions show that larger deficits and greater reliance by governments on the inflation tax and financial repression are associated with less central bank independence. Notes 1 Royal Commission on Indian Currency and Finance. Mins. of Ev., vol. v (1926) Non-Parl. Qn. 14597. 2 See for example Cukierman (1992); Grilli, Masciadaro and Tabellini (1991); and Eijffinger and Scaling (1993). 3 Mangano (1998). 4 Some central banks in our questionnaire did not complete this questio lanswers from others were excluded because they referred explicitly only to the independence of their own central bank 5 From the responses, instrument independence could be subdivided into independence to implement, operate, and set policy instruments, yet we found lite in the answers that would help us explain the implications of such a sub division © Sce Capie, Goodhart, Fischer, and Schnadt (1994), pp. 255-56. ical responses included: “The extent to which the central bank can act effectively to fulfil its statutory objectives without politcal interference” andun B What does independence mean to central banks? 19 “The ability of the central bank to pursue statutory objectives without undue influence from other government officials or private parties ‘This is often termed ‘opportunistic disinflation’, a term used by Blinder (1994). Debates on the question include an illuminating exchange of views between Stanley Fischer and Donald Brash, Governor. Reserve Bank of New Zealand See Capie, Goodhart, Fischer and Schnadt, 1994, pp. 302 and 310). Fischer states the view that: ‘The Bank’s inflation goals for the next three years should bbe announced, after consultation with the Treasury.” In response, Brash argues that although’ the RBNZ is not goal independent, the framework works because itis one where “I can force the hand of the Minister if and only if the Minister is seeking to fudge on the price stability objective, while the Minister ean force my hand (by sacking me) if and only if Iam seeking to fudge on the self-same objective’ Cukierman (1992), p. 372 defines policy formulation as ‘concerning the resolu tion of eonficts between the executive branch and the central bank and the degree of participation of the central bank in the formulation of monetary policy and in the budgetary process”. He distinguishes this from the extent to Which the final objectives as stated in the central bank charter focus on price stability, Wo recognise that subjectivity remains even in the ‘more objective’ measures. But for convenience we continue with the use of the word ‘objective’ The theoretical literature, eg. Canzoneri and Diba (1996), Sargent and Wallace (1981), Woodford (1995, 1996), focuses only on the size and sustain- ability of the government deficit. With the exception of Masciandaro and ‘Tabellini (1988), however, there appears to be no empirical work on the rela tionship between deficits and central bank independence (Eijffinger and De Haan, 1996). Using a similar approach, Eijfinger, Van Rooij, and Schaling (1996) estimate ‘monetary policy reaction functions with changes in money market interest rales as the dependent variable to measure central bank independence in industrial countries. However, they take the country dummies rather than the shift parameters as their measure of central bank independence.