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FRBSF

WEEKLY LETTER

Number 95-16, April 21,1995

Central Bank Independence
and Inflation
The following is adapted from a speech delivered by Robert T. Parry, President and Chief
Executive Officer of the Federal Reserve Bank of
San Francisco, before the College of Business
Administration at the University of Iowa on
March 29, 1995.
My remarks today focus on the link between
central bank independence and the pursuit of
low-inflation policies. This is a timely issue,
because a number of countries-in Western
Europe, Central Europe, and even China-have
been considering changes to their central banks'
structures.
I think central bank independence is an especially interesting issue because a lot ofthe research on it revolves around an age-old human
problem-temptation. The temptation in this
case isn't like the one Eve faced in the Garden
of Eden, when the snake offered her fruit from
the Tree of Knowledge. The temptation instead is
to allow a high-inflation environment to develop
in the economy.
You might think the comparison of Eve's temptation and the temptation to inflate is ridiculous.
After all, her punishment was mortality and eternal banishment from Eden. But according to
Dante's Inferno, the punishment for people who
debase the currency could be pretty rough, too
-the tenth pit of the eighth circle of Hell, to
be exact.
As a conservative central banker, I can easily
think of a number of reasons to justify Dante's
harsh treatment of inflators. To begin with, a
higher level of inflation is generally associated
with higher uncertainty about inflation. And
higher uncertainty about inflation means more
difficult planning and contracting by business
and labor. It also means higher risk premia in
long-term interest rates, which depress capital
formation and productivity.

In fact, 600 years after Dante, Lenin said the best
way to destroy the capital ist system was to debauch
the currency. And according to Keynes, Lenin
was right.

Temptation and central bank independence
I'd like to start by describing how temptation
plays a role in justifying central bank independence. Basically it has to do with the difference
between monetary policy's effects in the short
run and the long run. In the short run-say, six
to nine months-an "easy" monetary policy
can stimulate the economy to grow faster and to
lower the unemployment rate. But persistently
stimulating the economy to get gains in output
and employment is an exercise in futility. The
reason is that, in the long run, output and unemployment depend mainly on real factorssuch as population growth and improvements in
technology and productivity. So eventually the
monetary effects on the real economy dissipate,
and rather than long-run gains in output and unemployment, all we end up with is persistently
high and volatile inflation. And that in itself takes
a toll on economic growth.
Furthermore, as we learned from the early 1980s,
once inflation gets going, it's costly to bring it
under control. Back in 1980, (PI inflation was
running at over 12 percent a year, and 30-year
fixed-rate mortgages were as high as 16 percent.
By 1982, the annual inflation rate was down to
3.8 percent. But to get there we went through a
double-dip recession with over 10 million in the
ranks of the unemployed.
Temptation enters the picture because it's natural
to let near-term concerns obscure considerations
about long-term consequences. In the standard
story involving monetary policy, it's elected officials who could be tempted to be short-sighted
in their efforts to expand the economy. With elections on the near horizon, they'd be tempted to
try to ensure their return to office by pushing the

FRBSF
central bank to follow an "easy" policy, figuring
they can deal with the resulting inflation when it
shows up later on.
The more political pressure on the central bank,
the more likely this short-sighted strategy will be
followed. As I said, in the long run, this strategy
doesn't lead to any gains in employment oroutput, it just leads to higher, more volatile inflation.

out in the Humphrey-Hawkins Act. In addition,
the Chairman, the Governors, and the Reserve
Bank Presidents give testimony before Congress
on a number of issues. Furthermore, the Fed meets
regularly with senior Administration officials to
discuss one another's respective economic programs. In fact, the phrase usually used to describe
the Fed is "independent within government."

Independence, goals, and credibility
But that's not all. It also leads people to expect
higher inflation. Because the public believes that
if politicians can pressure the central bank into
an "easy" policy once, they can do it again.
Under these circumstances, a central bank would
have a hard time convincing anybody that it was
serious about maintaining low inflation. In other
words, the public wouldn't think that the central
bank's commitment to a low-inflation policy was
credible. For a central banker, this is the worst
of all possible worlds. Without a credible lowinflation policy, the only way the central bank
can slow inflation down is to step on the economic brakes hard. And the result can be a deep
recession with many jobs lost.

The Federal Reserve's structural independence
One way to insulate monetary policy from dayto-day political pressures is to give the central
bank a more independent structure. In this respect, the Fed ranks toward the top among the
world's central banks. So I'll draw from the Fed to
describe some of the elements of an independent
structure.
First, the Governors on the Board are appointed
to 14-year terms-not as long as Supreme Court
Justices, but much longer than congressional or
presidential terms. Althoughthey're political appointees-in that the
President nominates
them and the Senate confirms them-their terms
aren't tied to an election cycle. Second, the
Reserve Bank presidents-like me-aren't appointed by any politician. Instead, we're selected
by our Reserve Bank's Board of Directors and approved by the Board of Governors. This provides
further insulation from partisan politics. Third,
the Fed covers its own operating expenses, so it
isn't dependent on Congressional appropriations.

u.s.

I want to stress that independence does not mean
that the Fed is free of accountability to the government. For example, the Fed-like virtually all
central banks-has its goals set by the government. In the case of the U.s., the goals are laid

There is a way beyond such structural means to
make monetary policy even more independent of
political pressure to inflate. And that way is for
the Congress to give us a clear statement that low
inflation is our goal. The Humphrey-Hawkins Act
actually does this, by calling for an inflation rate
in the range of 0 to 3 percent.
But it also calls for unemployment in the range of
3 to 4 percent. Just about any economist you talk
to will tell you that, in today's economy, you
can't achieve both goals at once-and furthermore, it's virtually impossible to achieve the
unemployment goal at all! This combination of
goals sends the Fed mixed signals, where almost
any policy approach-from "easy" to "tight"is technically consistent with the instructions
from Congress.
In this session of Congress, Senator Connie Mack
(R) of Florida actually has proposed legislating
low inflation as the Fed's only goal. Such a change
would not only reduce the Fed's exposure to pressures to inflate, but some economists also have
argued that it may add credibility to the Fed's
low-inflation policy.
In fact, on just those grounds a. number of other
countries recently gave their central banks specific low-inflation goals. So now let me take a
look at how their experiences with independence, goals, and credibility have worked out.
Since 1990, the governments of New Zealand,
Canada, and the United Kingdom have worked
with their respective central banks to adopt specific low-inflation targets. And, so far, all three
countries have achieved their inflation objectives.
But the evidence also suggests that the lowinflation regimes in these countries aren't fully
credible (Ammer and Freeman 1994). For example, surveys show that the public's expectation
of inflation remains somewhat above actual inflation, although expectations have come down
since the introduction of the targets. That prob-

ably means that it takes more than inflation targets and a few years of success to establish full
credibility.
The example of japan drives home the point. The
Bank of japan has neither political independence
nor formal inflation mandates. Yet because inflation in japan has averaged only around 2 percent
for the last 10 years, the Bank of japan is among
the world's most credible central banks.
But that's not to say that an explicit low-inflation
mandate or target from Congress wouldn't help
-and help significantly-in the
I personally support proposals that make low inflation the
central bank's primary goal. In fact, when former
Representative Stephen Neal (D) of North Carolina held hearings on a similar plan a few years
ago, I testified in favor of it. I think such a goal
would help in a number of ways: It would help
us avoid the pressures for higher inflation, it
would add to the Fed's accountability to the
Congress and the public, and it would help us
solidify and extend the significant gains against
inflation that the Fed has made in the last decade
and half.

u.s.

a

Conclusion
In closing, let me restate what I believe are the
most important issues in discussions of central

bank independence: First, the temptation to focus on the short run rather that the long run can
thwart the best efforts to maintain low and stable
inflation. Second, some approaches-namely,
structural independence and low-inflation goals
-can help fend off those temptations. Finally,
although the Fed has made considerable progress
against inflation over the last 15 years, we still
have our work cut out for us, and we can't afford
to relax our vigilance.
To return to Dante, I urge continued vigilance not
because I think the alternative is spending eternity in the eighth circle of Hell. I urge it because
achieving and maintaining low and stable inflation is the best way the Fed-or any other central
bank-can contribute to long-run, sustainable
growth in the economy.

Robert T. Parry
President and Chief Executive Officer

Reference
Ammer, John, and Richard T. Freeman. 1994. "Inflation
Targeting in the 1990s: The Experiences of New
Zealand, Canada, and the United Kingdom:' International Finance Discussion Paper Number 473.
Federal Reserve Board Oune).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department"Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
'
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper Q
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.6.

~

Index to Recent Issues of FRBSF Weekly Letter

DATE

NUMBER TITLE

AUTHOR

10/28
11/4
11/11
11/18
11/25
12/9
12/23
12/30
1/6
1/13
1120
1/27
2/3
2110
2117
2/24
3/3
3110
3/17
3/24
3/31
4/7
4114

94-37
94-38
94-39
94-40
94-41
94-42
94-43
94-44
95-01
95-02
95-03
95-04
95-05
95-06
95-07
95-08
95-09
95-10
95-11
95-12
95-13
95-14
95-15

Zimmerman
Moreno
Gabriel
Kasa
Zimmerman
Booth/Chua
Mattey
Spiegel
Trehan
Parry
Levonian
Furlong/Zimmerman
Rudebusch
Hutchison
Mattey/Dean
Levonian/Furlong
Spiegel
Moreno
Mattey
Dean
Judd/Trehan
Glick/Moreno
Huh

Bank Business Lending Bounces Back
Explaining Asia's Low Inflation
Crises in the Thrift Industry and the Cost of Mortgage Credit
International Trade and u.s; Labor Market Trends
EU + Austria + Finland + Sweden + ?
The Development of Stock Markets in China
Effects of California: Migration
Gradualism and Chinese Financial Reforms
The Credibility of Inflation Targets
A Look Back at Monetary Policy in 1994
Why Banking Isn't Declining
Economy Boosts Western Banking in '94
What Are the Lags in Monetary Policy?
Central Bank Credibility and Disinflation in New Zealand
Western Update
Reduced Deposit Insurance Risk
Rules vs. Discretion in New Zealand Monetary Policy
Mexico and the Peso
Regional Effects of the Peso Devaluation
1995 District Agricultural Outlook
Has the Fed Gotten Tougheron Inflation?
Responses to Capital Inflows in Malaysia and Thailand
Financial Liberalization and Economic Development

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.