The First Major Stress Test in Over 30 Years
For anyone who came of age since 1990s, central bank independence has seemed a permanent feature of modern governance. Like the separation of powers, the idea that politicians should not set interest rates became an accepted norm across advanced economies and increasingly elsewhere too.
Yet it is relatively recent. For most of the twentieth century, governments heavily influenced monetary policy, at times seeking to juice up growth before elections or to avoid difficult fiscal choices. However, experience repeatedly showed that political control of monetary policy leads to higher inflation and more volatile growth.
Over the past three decades, operational independence became the global standard: elected officials set the objectives, typically price stability and sometimes maximum employment or growth, while independent central bankers appointed for long terms decide how to achieve them.
For much of this period, the model faced little resistance. Inflation remained largely contained as central banks confronted repeated crises, a long stretch of below-target inflation post-2008 and then a global pandemic. Their decisions occasionally drew criticism, but independence was seldom questioned.
That era has ended. Today, central bank independence faces the most serious challenge in its history, squeezed between difficult economic realities and growing political opportunism.
The Economic Challenge: Debt and Supply Shocks
Central bank independence exists primarily to prevent governments from succumbing to two temptations: inflating away excessive public debt and prioritizing short-term growth over price stability. Both risks have returned.
The first is public debt. Across the G7, debt-to-GDP ratios are at levels unseen outside wartime and often still rising. When interest rates were exceptionally low and often below growth rates, carrying that debt was manageable Today, borrowing costs have risen amid increased sharply as a result of expectations of tighter monetary policy and competition for capital between governments and businesses to finance simultaneously rearmament, artificial intelligence, resilience, the energy transition and ageing populations.
Because growth rates have not risen commensurately, the fiscal adjustment required to stabilize or reduce debt burdens has increased. This raises the risk of "fiscal dominance", where central banks come under pressure to keep rates low or use their balance sheets to support government financing.
Moreover, across much of the G7, particularly in the United States, debt maturities have shortened. Shorter maturities heighten the risk by making government borrowing costs more sensitive to central bank decisions.
The second challenge is inflation’s changing nature. Between the 1980s and the pandemic, inflation fluctuations were primarily demand-driven. More recently, supply disruptions from geopolitical tensions, climate events and public health crises have become more important and are likely to remain a feature of the current environment.
In these circumstances, achieving price stability is more difficult. Higher interest rates cannot create missing goods or repair broken supply chains. At best, they can prevent temporary price increases from becoming entrenched through wage-price spirals. Even if credible central banks ultimately succeed, they may have to take actions that hurt borrowers, including households, companies and governments, leaving them vulnerable to political attacks.
The Political Assault
These economic challenges come at a time when the political consensus supporting central bank independence is weakening, owing to several waves of controversial decisions. During the global financial crisis, central banks intervened heavily to stabilize financial systems. Later, they adopted large-scale asset purchases programs, or quantitative easing, to combat persistently low inflation. More recently, years of inflation above target have led some to question central banks' competence and legitimacy, and even some policymakers to challenge their independence.
Defending the Institutional Shield
The economic costs of weakened central bank independence are substantial. If investors doubt a central bank's willingness or ability to maintain price stability, inflation expectations can become unanchored. Risk premiums rise, bond yields increase and borrowing costs for households, firms and governments climb. Growth suffers as a result.
These risks are amplified as sovereign debt markets are increasingly inhabited by flighty and price-sensitive investors such as hedge funds as opposed to buyers such as central banks and pension funds. Market reactions can be swift; restoring lost credibility typically requires painful measures and larger economic sacrifices.
Independent central banks are not unaccountable. They must explain their decisions clearly and convincingly, helping citizens understand why short-term pain may be necessary to avoid greater long-term damage. But they cannot be the only ones defending their independence. Business leaders, investors, researchers and policymakers should do it too. Undermining it will not eliminate deficits, reduce living costs or resolve geopolitical tensions. It will merely remove one of the most effective safeguards against short-sighted macroeconomic policymaking.
