By Tobias Adrian, Financial Counsellor and Director of the Monetary and Capital Markets Department, International Monetary Fund (IMF)
Independence has long been a cornerstone of central banking. Research and empirical evidence confirm that central banks’ ability to set an appropriate course of monetary policy absent political interference is a vital part of their ability to control inflation. However, within a more challenging environment in terms of economic growth and inflation, as well as expanded mandates, central banks’ stakeholders increasingly scrutinize their policies and operations and may question the validity of their independence. Indeed, in today’s world, parliaments, market participants and the general public have increased expectations of what the central bank can and should do.
Stakeholders need the appropriate reassurance that central banks’ independence serves the public interest. And, to be sure, there are actions central banks themselves can take that will help safeguard their independence while at the same time ensuring policy credibility. Before turning to a discussion on the various tools at their disposal, it is useful to step back first and assess the current environment in which central banks find themselves.
A challenging environment for independence
Many central banks are under increasing pressure on several fronts. Post-pandemic inflation levels have required central bankers to tighten monetary policy. However, this has created significant political pushback as it has caused growth to slow, unemployment to rise and fiscal positions to deteriorate. Additionally, the financial-stability measures taken by central banks, including emergency liquidity assistance and bank resolution, have led to further expanded balance sheets—and also come with increased financial risks for central banks. To complicate things further, while price stability remains the overarching mandate for most central banks, more and more central banks have added objectives related to financial integrity, financial inclusion, consumer protection, financial technology (fintech) and climate change. Moreover, central banks are expected to meet the same standards of governance, risk management and transparency that are applied in the financial sector. (A recent International Monetary Fund [IMF] working paper outlines how a more forward-looking and risk-based approach may be desirable in helping protect central banks’ financial autonomy and, ultimately, independence.1)
Within this overall context, the manner and extent to which central banks use their independence are often questioned. In the United States, there have been calls for stronger oversight of the Federal Reserve (the Fed). In Europe, the European Central Bank (ECB) was critiqued for its use of quantitative easing and lack of accountability. In the United Kingdom, a recent report2 called for more oversight of the Bank of England (BoE). And in developing economies, central banks have faced recurrent pressures on their independence (often prompting the IMF to address these pressures via program conditionality as part of the Fund’s lending to developing economies). With increased calls for more oversight, it begs the question: Why is central bank independence necessary, and how can independent central banks be held accountable?
Independence is critically important for monetary policies that are aimed at low and stable inflation, which is confirmed by various studies.3 Research based on the IMF’s Central Bank Legislation Database4 shows that most countries’ laws pertaining to their central banks contain “anchors” to safeguard these central banks’ independence.5 These laws aim to insulate monetary policy from political interference. Such interference could undermine central banks’ goals and potentially create long-term risks to economic and financial stability. Any short-term political gains could potentially invite long-term pain in the form of higher inflation.
The IMF’s managing director, Kristalina Georgieva, stated it clearly earlier this year when she noted that “independence is critical to winning the fight against inflation and achieving stable long-term economic growth”.6 On this point, the data is clear: Stronger central bank independence is clearly associated with lower inflation. But she also highlighted that policymakers risk facing pressure due to political forces questioning central banks’ independence. This holds for advanced, emerging and developing economies alike, especially in times of general elections.
Assessing and strengthening independence
A new global index developed by IMF staff incorporates various key metrics for assessing independence and is aimed at helping central banks and policymakers strengthen central banks’ independence.7 It is the first new central bank independence index in 30 years. And even though it builds on existing indices, it includes new variables, such as financial and budgetary independence, board composition and the role of state audit bodies. Interestingly, the variable of financial independence was rated by central banks as the most critical component of central banks’ independence, whereas the prohibition of short-term lending to the government was rated as comparatively less important.
The new index consists of 10 key metrics, which are weighted using data collected from 87 central banks. These metrics reflect important dimensions of a central bank’s design from the perspective of monetary-policy autonomy. The index uses data from critical IMF databases to ensure a solid foundation for country scoring. It is the first index that correlates positively with inflation-targeting central banks—highlighting that independence is significantly stronger in countries where inflation targets are more firmly entrenched in the central bank’s operations.
The notion of central bank independence is multifaceted, and the index shows that weak points can arise in different areas. Independence is sometimes lacking at a central bank’s governor and board levels, but there are also often shortcomings in budgeting and financial independence, monetary-policy independence, as well as in the prohibition of short- and long-term lending to the government or the prohibition of lending outside the financial system.
Strengthening the central bank’s independence often requires legislative changes, which can be a delicate exercise. However, specific IMF tools can help and do not require embarking on a legislative-reform path. The first tool is the IMF Central Bank Transparency Code (CBT),8 which was published in 2020.9 It was developed in part because of increased pressures on central banks and the calls of parliaments and other stakeholders for central banks to be more transparent. It has five pillars, covering transparency over the governance of the central bank, its policies, its operations and the outcomes of those operations, as well as its official relations with its key stakeholders. It is designed to be applicable to any central bank under any set of circumstances.
Of course, the CBT’s focus is not full transparency. Instead, the code makes it clear that there are legitimate needs for confidentiality—for instance, when it comes to foreign-exchange interventions or other sensitive or personal data.
The benefits of a CBT review for a central bank are fourfold: First, it will improve the central bank’s transparency practices and communication framework, leading to policy credibility. Second, it will strengthen its relations with stakeholders, such as parliament, market participants and the public at large. Third, it will facilitate peer learning among central banks. Finally, it can help in other engagements with the IMF, for instance, in the context of a financial-sector assessment, conditionality under IMF lending programs and regular surveillance of economies. To date, the IMF has already conducted nearly 10 CBT reviews for central banks all over the world, including those of Canada, Chile, Oman and South Africa, and is planning to conclude four more reviews in the next six months. (As part of a pilot exercise, CBT reviews were conducted for the central banks of Canada, Chile, Morocco, North Macedonia, Seychelles, Uganda and Uruguay. These pilot reviews were summarized in a policy paper.10 The separate CBT portal11 contains all relevant detailed information on the Central Bank Transparency Code, including published review reports, guidance notes and other documents.)
In fact, in all the recently completed CBT reviews, the central banks involved used the review to strengthen their transparency, engage more closely with their stakeholders and, as a result, enhance their accountability and policy credibility. The Bank of Canada (BoC), for instance, published its internal deliberations after each policy-rate announcement for the first time. The National Bank of North Macedonia (NBRM) presented CBT findings to the country’s ministries and assembly, with the governor highlighting how the central bank’s independence was used to conduct effective policies transcending political cycles. And the Bank of Chile published a detailed roadmap of how additional transparency measures could be implemented, with the governor presenting these to the National Congress. These actions exemplify how central banks increasingly recognize that, in exchange for their strong independence, they must be transparent and accountable.
A second tool offered by the IMF is central bank balance-sheet stress testing, which is intended to help central banks assess their financial independence. This is particularly relevant for central banks in advanced economies where balance sheets were expanded in the wake of the pandemic due to significant quantitative easing and asset-purchasing programs. However, even for jurisdictions that did not engage in quantitative easing but where central banks have large foreign-exchange portfolios due to their foci on stable exchange rates, central banks are exposed to interest rate risk (IRR) and duration risk on their foreign-exchange securities. Both of these risks are often not properly accounted for in central banks’ capital policies. Of course, emerging-market (EM) central banks also remain exposed to foreign-exchange losses on their entire portfolios solely emanating from changes in their nations’ exchange rates. This is important for governments as well: A central bank’s deteriorating balance sheet would negatively affect profit distribution—ultimately creating fiscal risks, including possibly having to recapitalize the central bank.
The IMF’s central bank balance sheet tool, therefore, combines a core modeling framework with stress testing of various extreme but plausible scenarios. This leads to granular projections of the state of the balance sheet and the effects on the central bank’s capital over time, serving to inform decision-making by the central bank’s board and as a foundation for discussions with the government. A risk-based central bank capital approach, therefore, ensures sufficient capital, protecting the central bank’s financial independence, policy credibility and solvency.
Note: A risk-based framework for managing equity is composed of four parts: (1) determination of a minimum equity level (ME), which is a function of the central bank’s operating expenditures, the carrying cost of international reserves, the demand for base money, and other factors; it is the minimum equity needed to ensure the credibility of its policy objectives—usually the inflation target; (2) determination of an equity buffer (β), which is necessary to retain credibility in the face of shocks, and is determined in the context of a forward-looking risk assessment (ME + β establishes the long-term target capital level); (3) determination of a maximum level of capital (ME + β*c), which is the maximum level of capital the central bank should retain, where ‘c’ is a constant; and (4) a mechanism that ensures that equity (E) remains above ME, and no higher than ME + β*c, which would be defined in the central bank’s realized profit distribution and recapitalization clauses that should be entrenched in the organic law. The determination of profit should be based on the application of internationally recognized accounting standards (such as IFRS) and audited by a reputable and experienced audit firm.
Finally, a central bank operational-efficiency review is a third tool that central banks can use to enhance their independence and policy credibility. Emerging-market central banks have significantly higher operational costs and are notably less efficient than central banks in advanced economies, as depicted by the cost-efficiency scores in the figure below. As part of the review, a central bank’s cost efficiency can be calculated, whereby policy-related costs are left out (as these are a necessity), but other costs related to staffing, procurement, cash-currency management, subsidiaries and other logistics costs—such as those related to building maintenance—are benchmarked against international best practices as well as against other domestic agencies and central banks in the region. This helps the central bank’s board make well-informed decisions regarding operational costs and explain its decisions to key stakeholders, thereby strengthening independence.
In summary, while many central banks worldwide are under pressure, it remains clear that their independence pays off in the long run. For many central banks, there is room to improve their independence, and the IMF offers tailored tools that central banks worldwide can use to strengthen their independence and, ultimately, policy credibility. With central bankers, government leaders, legislatures and other stakeholders working together, the independence, transparency and accountability of central banks can be preserved and strengthened for the benefit of future generations.
References
1 International Monetary Fund (IMF): “New Perspectives on Quantitative Easing and Central Bank Capital Policies,” Tobias Adrian, Christopher J. Erceg, Marcin Kolasa, Jesper Lindé, Roger McLeod, Romain M. Veyrune and Pawel Zabczyk, May 17, 2024, IMF Working Paper 24/103, Washington, DC.
2 House of Lords Economic Affairs Committee: “Making an independent Bank of England work better,” November 27, 2023, 1st Report of Session 2023–24/HL Paper 10.
3 International Monetary Fund (IMF): “Central Bank Independence and Inflation in Latin America—Through the Lens of History,” Luis Ignacio Jácome and Samuel Pienknagura, September 16, 2022, IMF Working Paper 22/186, Washington, DC.
See also:
International Monetary Fund (IMF): “Monetary Policy Frameworks: An Index and New Evidence,” D. Filiz Unsal and Chris Papageorgiou, November 7, 2023.
4 International Monetary Fund (IMF): IMF Data: Access to Macroeconomic & Financial Data.
5 International Monetary Fund (IMF): “A New Measure of Central Bank Independence,” Tobias Adrian, Ashraf Khan and Lev Menand, February 23, 2024, IMF Working Paper 24/35, Washington, DC.
See also:
International Monetary Fund (IMF): “Monetary Policy Frameworks: An Index and New Evidence,” Filiz D. Unsal, Chris Papageorgiou and Hendre Garbers, January 28, 2022, IMF Working Paper 22/22, Washington, DC.
6 International Monetary Fund (IMF) Blog: “Strengthen Central Bank Independence to Protect the World Economy,” Kristalina Georgieva, March 21, 2024.
7 International Monetary Fund (IMF): “A New Measure of Central Bank Independence,” Tobias Adrian, Ashraf Khan and Lev Menand, February 23, 2024, IMF Working Paper 24/35, Washington, DC.
8 International Monetary Fund (IMF): “Welcome to the website of the IMF’s Central Bank Transparency Code (CBT).”
9 International Monetary Fund (IMF): “The Central Bank Transparency Code,” July 2020, IMF Policy Paper, Washington, DC.
10 International Monetary Fund (IMF): “The Central Bank Transparency Code—Findings of the Pilot Reviews,” March 15, 2023, IMF Policy Paper, Washington, DC.
11 International Monetary Fund (IMF): “Welcome to the website of the IMF’s Central Bank Transparency Code (CBT).”