Powell-Trump clash: Central bank independence matters for economic growth and financial stability

Calling the Department of Justice probe into the testimony he gave last year to a Senate panel on renovations of Fed buildings “unprecedented," Powell said he believed the action was a direct consequence of the president’s anger over the Fed’s refusal to reduce interest rates despite White House pressure.

There seems little scope for scandal in a prima facie case of cost-overruns and a lavish budget for a premises upgrade. But history has shown that central banks that are shielded from political influence deliver better economic outcomes—especially price stability—than those ready to buckle under it.

This stands to reason.

Elected governments typically take a short-term view shaped by an electoral cycle. Central banks, in contrast, can afford a longer view even if it means near-term pain. Plus, as guardians of fiat money, they must not let it get debased needlessly. In general, the need to meet publicly set goals like inflation control explains why the autonomy of a monetary authority is seen to help keep an economy stable.

Granted, absolute freedom is a myth. After all, the central bank is an arm of policy, if not directly of government policy. Both the US Fed and Reserve Bank of India (RBI) are governed by statutes: the Federal Reserve Act of 1913 and RBI Act of 1934, respectively. Although these laws do not explicitly talk of ‘independence,’ both have significant leeway on operations.

To a purist, this might not fully tick the box of that ideal, but it is critical to prevent decisions being muddled by politics. For this, an institutional framework that lets them operate freely can suffice.

The Fed, like RBI, operates with so-called instruments of operational independence. It can raise or lower interest rates, or buy and sell Treasury bonds, without interference from the government.

It has two statutory protections: one, the appointment of its governors for 14-year terms on a staggered basis; and two, a stipulation that governors can be removed by the president only for inefficiency, neglect or malfeasance in office—so that policy quarrels cannot lead to their ouster.

In India, RBI was granted formal space to take its own calls rather more recently, after the RBI Act was amended in 2016 to designate it as an inflation-targeter. This requires a policy-level handle on interest rates. Accordingly, the repo rate is decided by a six-member Monetary Policy Committee (MPC) that has three RBI officials and three external experts appointed by the government, with the governor given a casting vote in the event of a tie.

The Fed’s decisions, likewise, are made not by the chair alone, but by a majority vote of the Federal Open Market Committee. The idea, as with the MPC, is to limit the power of any one individual over monetary policy.

Thus, independence allows a central bank to pick a path best suited to meet its objectives, regardless of what the government of the day might want (typically, cheaper credit).

Such a set-up matters all the more for a country like India, where elected administrations are given to looking for short-term fixes. If the US stakes appear higher, it is because the American dollar and Treasury bonds play a central role in global finance. And financial markets need a credible assurance that the Fed goes by the book.