Assessing the role of central bank independence in effective inflation management

By Bright BOATENG

Inflation is a key macroeconomic variable that affects the stability of an economy. It represents the rate at which the general price level of goods and services in an economy rises, eroding purchasing power and affecting various aspects of economic stability.

Controlling inflation is a primary goal of monetary policy, and the level of independence granted to a central bank significantly impacts its ability to manage inflation effectively.

An independent central bank, free from political influence, can focus on long-term price stability. This article examines the importance of central bank independence, its role in controlling inflation, potential trade-offs, and the specific case of the Bank of Ghana.

Central bank independence: Concept and importance

A central bank is the institution responsible for formulating and implementing monetary policy in an economy. This includes setting interest rates, controlling money supply, and managing foreign exchange reserves, all of which have direct implications for inflation.

The concept of central bank independence refers to the degree to which a central bank can operate without interference from the government, particularly from politicians or elected officials who may have short-term incentives that conflict with the long-term economic goals of price stability.

The idea behind granting independence to central banks is rooted in the notion that political leaders, particularly in democratic societies, may prioritize policies that spur short-term economic growth or reduce unemployment, especially near election cycles, even if those policies lead to inflationary pressures.

By separating monetary policy from political influence, independent central banks can focus solely on controlling inflation and maintaining economic stability, rather than being swayed by short-term political interests.

Mechanisms of independent central banks in managing inflation

Commitment to price stability

An independent central bank typically operates with a clear mandate to maintain price stability. When a central bank is not under direct political control, it can commit credibly to a long-term policy aimed at keeping inflation low and stable.

This can anchor inflation expectations in the economy, meaning that households and businesses will make decisions based on the expectation that inflation will remain under control.

Credibility and inflation expectations

One of the major benefits of central bank independence is that it enhances the credibility of monetary policy. When a central bank is seen as free from political pressures, market participants are more likely to trust its commitment to maintaining low inflation.

This trust is crucial because inflation is not only a function of actual monetary policy but also of expectations about future policy. If people expect inflation to rise, they may adjust their behaviour by demanding higher wages or increasing prices, which can, in turn, create inflationary pressures.

An independent central bank can more effectively manage these expectations by signalling consistent and predictable policies aimed at price stability.

Interest rate decisions

Independent central banks are better able to use interest rates to control inflation. When inflation starts to rise, the central bank can raise interest rates to reduce spending and investment in the economy, which helps cool demand and bring inflation down.

Because it is independent, the central bank can raise interest rates even when it is politically unpopular to do so, such as during periods of slow economic growth or high unemployment.

By contrast, a government-controlled central bank may be reluctant to raise rates for fear of political backlash, leading to delayed or insufficient policy action and allowing inflation to spiral out of control.

Long-term policy orientation

Independent central banks are often insulated from the pressures of election cycles and short-term political goals, allowing them to adopt a long-term approach to monetary policy.

While elected officials may prioritize policies that boost short-term economic growth or employment, these can sometimes come at the expense of higher inflation. Independent central banks can focus on achieving sustainable, long-term price stability without being swayed by temporary political concerns.

This is critical because inflation control requires a long-term perspective, and policies that are effective in reducing inflation may take time to yield results.

Empirical evidence supporting central bank independence

Lower inflation rates are strongly correlated with central bank independence, according to several research. In comparison to nations whose central banks are subject to more political influence, countries with more autonomous central banks often have slower and more stable inflation over time.

For instance, several advanced economies including the United States, Germany, and the United Kingdom moved toward enhancing the independence of their central banks throughout the 1980s and 1990s, which resulted in notable drops in inflation rates.

Another well-known example of an autonomous central bank with a strict anti-inflation mission is the European Central Bank (ECB).

Additionally, central banks also have a lower propensity to use inflationary financing techniques, such as money printing to cover budget shortfalls. Excessive use of this strategy, also referred to as “monetizing the debt,” might cause hyperinflation.

The government is normally prevented from using monetary policy to support its budgetary demands in nations with independent central banks, which promotes better fiscal discipline and lower inflation.

Trade-offs and challenges

While central bank independence has clear benefits for controlling inflation, it is not without its trade-offs and challenges. One potential downside is that an independent central bank may focus too narrowly on inflation control at the expense of other economic objectives, such as employment and economic growth.

This is particularly relevant in economies experiencing stagflation (simultaneous high inflation and high unemployment). Critics argue that overly tight monetary policy aimed solely at reducing inflation can sometimes exacerbate unemployment and slow down economic recovery.

Furthermore, while central bank independence reduces political interference, it can also lead to a lack of democratic accountability. Central banks are typically run by unelected officials who may make decisions that have significant effects on the economy.

If the public perceives that the central bank’s policies are too disconnected from broader economic goals, there may be a backlash against its independence. Striking the right balance between independence and accountability is, therefore, crucial for maintaining public trust in the institution.

The Ghana story

In recent decades, the concept of central bank independence has gained prominence as a crucial factor in promoting economic stability, particularly in developing nations like Ghana. The independence of the Bank of Ghana (BoG) is not merely a matter of institutional autonomy; it is a vital determinant of monetary policy effectiveness, inflation control, and overall economic health.

The Bank of Ghana became constitutional independence under the 1992 Constitution and the Bank of Ghana Act 2002 Act 612 made Bank of Ghana operationally independent.

The Act 612 and Bank of Ghana (Amendment) Act 2016 Act 918 explicitly established the maintenance of price stability as the primary objective of the Bank of Ghana.

The Acts however adds that without limiting this primary objective of price stability, the Bank shall (a) support the general economic policy of government, (b) Promote economic growth and development and effective and efficient operation of the banking and credit system; and (c) Contribute to the promotion and maintenance of financial stability in the country.

Many have critiqued this provision and argued that the additional objects of the Central Bank somewhat contribute to the institution’s independence as they could be conflicting objective of ensuring price stability and furthering economic policy of a government or ensuring price stability against pursuing economic growth.

For example, the Bank of Ghana’s primary objective of price stability can be threatened by its mandate to support the government’s economic policies, especially when the government prioritizes short-term growth through expansionary fiscal measures or deficit financing.

This creates conflicts where political pressure for economic stimulation can lead to inflationary pressures, undermining long-term price stability.

Critics of the Bank of Ghana’s (BoG) independence often point to potential political influences in the appointment, tenure, and removal of the Governor and the Board of Directors.

As outlined in Ghana’s constitution, the President appoints the Governor, the two Deputy Governors, and most of the Board members. This has raised concerns that political considerations may affect these appointments.

Again, the Governor and the Board are appointed to serve a four-year term with the possibility of reappointment, and the Bank of Ghana Act 612 (and its Amendment Act 2016, Act 918) offers protection for the Governor’s tenure.

Regardless of this provision, successive governments have often found ways to prematurely end the terms of governors appointed by previous administrations.

This is frequently done through voluntary or forced resignations, with the argument that new governments prefer to work with officials of their own choosing, despite the constitutional provisions that state the Governor can only be removed under the same conditions as a Justice of the Superior Court, per Article 184 (4d) of the 1992 Constitution and Section 12 of the Bank of Ghana Amendment Act. In contrast, countries like South Africa, Germany, and the United States have governors whose terms extend beyond the tenure of the sitting government, thus enhancing the independence of their central banks.

A further challenge to BoG’s functional independence is its role in financing the government’s fiscal deficits, which can undermine its monetary policy and inflation control. Excessive fiscal imbalances sometimes force the central bank to monetize government debt.

For instance, in 2019 and 2022, the Bank of Ghana was compelled to finance government debts of GHS 10 billion and GHS 45 billion, respectively, to support emergency expenditures. Many believe that this debt monetization fuelled inflation, complicating BoG’s inflation-targeting strategy.

This situation underscores why the IMF pushed for a zero-financing agreement between the government and the central bank to curb such practices.

The independence of a central bank plays a crucial role in maintaining price stability, particularly in an environment where political pressures could compromise long-term monetary policy goals.

For the Bank of Ghana, while its autonomy has allowed for effective inflation targeting, its mandate to support government economic policies can pose significant challenges.

The potential conflicts between pursuing price stability and supporting short-term fiscal objectives underscore the delicate balance required to maintain central bank independence.

Ensuring that the central bank remains focused on its primary goal of controlling inflation, while minimizing political interference, is essential for fostering sustainable economic growth and financial stability in Ghana.

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