Sayonara central bank independence?

How RBI’s own independence pans out in these trying times will be keenly watched.

The Trump era is truly on us. There is barely anything in politics and economics which is not being impacted or going to be impacted by Trump’s policies. In this Trump era, how can central bank independence be left behind?

In his first Presidency itself, Trump criticized both the Federal Reserve and its chairperson Jerome Powell. He appointed Jerome Powell as Chairperson of Federal Open Market Committee Trump (but did not think twice before venting out his anger on Twitter (now X). He even compared Powell to Chinese President Xi.

Even during Trump’s election campaign for the second presidency, he repeatedly said on being elected he would dismiss Powell. On his election, Trump has been unpredictable on his views on Federal Reserve criticizing it one day only to be sober the next day. Powell on his own has responded that he would not resign and President cannot dismiss him under the law. Going forward, Trump vs Powell could just be as heated as brewing up going forward.

Genesis of the idea of central bank independence

What is central bank independence and why do we care? The idea that central banks should be independent from the government (autonomous is a better term as independence suggests completely free from the government but that is not the case) emerged as an idea from the high inflation the world economy faced in the 1970s. The rise of inflation led to rise of monetarism school of economic thought which said that inflation is due to growth in money supply. If growth in money supply higher than nominal growth of economy, it results in inflation.

Monetarism shifted the focus of macroeconomic policy management from government’s fiscal policy to central bank’s monetary policy. The central banks implemented monetary targeting where money supply targets were adopted but the experiment was not successful. The central banks then shifted to inflation targeting where they targeted inflation using interest rates which met with incredible success.

Amidst these shifting frameworks, germinated another idea of central bank independence. Albert Alesina and Lawrence Summers in their landmark research showed how central banks that were more independent achieved both lower inflation levels and lower volatility compared to central banks that were less independent. The central bank independence was divided into two types of independence. The political independence also called as goal independence, is the ability of the central bank to select its policy objectives without influence from the government. Political independence also includes governance matters of the central bank which comprises appointment of key executives of the central bank. The economic independence also called as instrument independence, is using monetary policy instruments of without any restrictions.

The strong evidence of impact of central bank independence on inflation led to advocacy for more central bank independence. There was a broad agreement between governments and central banks that governments will set goals for the central bank and central banks will have instrument independence to achieve these goals. This contractual agreement also tied well with inflation targeting framework where governments set inflation targets for central bank and central banks deployed various instruments to achieve the targets.

Global Financial Crisis triggered questions

The 2008 global financial crisis was a turning point for central bank independence. The central banks were blamed for being too narrow in their pursuit of inflation objectives while ignoring other goals such employment and financial stability. Paul Tucker, former central bank official at Bank of England wrote a book where he argued that central banks are unelected officials and should not become over-mighty citizens.

Central banks such as that of New Zealand which pioneered the single goal of price stability and inflation targeting now had wider goals of financial stability and employment. The 2020 pandemic and geopolitical uncertainty saw both rising inflation and lower growth, complicating central bank policies.

Rise of extreme political movement threaten central bank independence

The multiple crises and conflicts since the Russia-Ukraine war has led to world politics again seeing a rise of extreme political movements, creating large risks for central bank independence. The Trump era is part of the larger political movement threatening independence of Federal Reserve. He has also been really vocal about dismissing Powell. There is also a broader concern that other leaders will also follow Trump’s book and undermine independence of their own central banks.

These concerns are reflecting in the speeches of central bankers and officials of international organisations. The respective heads of European Central Bank (ECB) President and Bank of International Settlements (BIS) have started the year 2025 by giving speeches on central bank independence. Christine Lagarde of ECB has argued that geopolitical uncertainties will make it difficult to achieve price stability. In such times, one needs central bank independence to addressing the macroeconomic challenges.

Agustín Carstens of BIS observes: “Central bank independence is a fundamental component of the social arrangements aimed at preserving trust in the value of money and keeping inflation under control”. He adds that one needs to continuously reinforce independence so that central bank can achieve their objectives effectively and enhance their credibility.

Indian situation

The RBI has just appointed a new Governor and also has a relatively new MPC, and awaits appointment of the fourth Deputy Governor. RBI has broad instrument independence but the government controls political independence by holding all the cards on key appointments of central bank officials. How RBI’s own independence pans out in these trying times will be keenly watched by the central bank watchers.