8. Central banks’ governance and operations
This chapter outlines the importance of central banks in ensuring price stability and thus contributing to economic development and financial stability. It provides an overview of how the central bank can be institutionalised through the constitution. It shows that central bank legal frameworks vary across countries, reflecting differences in history and legal systems, and that while in some countries the central bank's role and responsibilities are referred to in the constitution, in most countries they are set out in detail in primary legislation in the form of a specific central bank law. This chapter stresses that, irrespective of the legal framework and specific arrangements, central bank independence requires legal guarantees of operational autonomy combined with accountability and transparency requirements.
While there is no commonly accepted international standard dealing with the independence of central banks, there is strong agreement among scholars and policy makers on the merits of having a central bank with both de facto and de jure independence.
Independence in monetary policy conduct ensures that the central bank sets and implements policy to achieve its mandate without interference from the government, while the objectives of monetary policy can be set by the government.
Strong legal provisions are key to ensuring central bank independence; they may or may not be included in the constitution.
Central bank legal frameworks vary across the benchmark countries. In most of them the roles and functions of the central bank are set in primary legislation in the form of a specific central bank law. Only in a few countries are the central bank's roles and responsibilities defined in the constitution, and even in those cases provisions are specified in a central bank law.
The overall strength of central bank independence depends on provisions regarding mandates, functions and governance rules, and requires an appropriate level of accountability and transparency.
All of the benchmark countries identify price stability or stability of purchasing power as the primary mandate; some central banks have additional objectives. In a number of cases, broad goals (price stability, full employment) are established in constitutions or primary legislation, but the central bank determines operational targets that it considers to be consistent with those goals.
Strong legal provisions are needed to ensure that the central bank governor and members of the monetary policy-setting committee are protected from unilateral government appointment or dismissal, and enjoy the full legitimacy of non-elected professionals in carrying out their duties. Only a few countries have constitutional provisions about the appointment and/or dismissal of the central bank governor.
In most benchmark countries, primary legislation prevents central banks from financing government expenditure or purchasing debt directly from the government; some of them have this provision in the constitution.
Only a few countries have provisions that explicitly prohibit other governmental and political bodies from seeking to influence central bank officials, or prohibit the central bank from taking instructions from others.
An independent central bank should be accountable to lawmakers and the public. There is no best-practice compromise between independence and accountability; practical solutions differ among benchmark countries. A few countries specify legal provisions for central bank accountability in the constitution or an international treaty.
Since the 1990s, many OECD countries have made legislative changes to ensure central bank autonomy in conducting monetary policy. These changes were motivated by cross-country evidence that a lack of de jure or de facto central bank operational independence from government resulted in high inflation. That consequence in turn undermined the stability of currency and real incomes and increased the cost of credit, with negative implications for economic growth and the distribution of income and wealth.
This chapter reviews legal frameworks of central bank governance and operations in 12 benchmark countries, covering both advanced and emerging-market economies: Australia, Brazil, Costa Rica, the euro area, India, Mexico, New Zealand, Poland, Sweden, Switzerland, Turkey and the United States. All of these but Costa Rica and Switzerland have adopted an inflation-targeting regime.
The importance of central bank independence
The objectives and status of central banks have evolved over time.1 In recent decades, central banks have played an important role in ensuring price stability and thus contribute to economic development and financial stability. Their independence developed out of concern that governments pursuing short-term political goals could resort to forcing central banks to finance excessive government spending by issuing (“printing”) money. Prolonged and excessive money creation by central banks has frequently lead to high inflation and even hyperinflation, and considerable depreciation of domestic currency. This in turn has been associated with negative economic consequences, such as falling real incomes (especially for lower-income households), high nominal and real interest rates, and heightened economic uncertainty, all of which have undermined consumer spending and business investment (Adrian and Khan, 2019[1]) (Weidmann, 2019[2]; Sargent, 1982[3]).2
The relationship between the independence of central banks and price stability has been subject of an intense academic research, resulting in a strong agreement among academics and policy makers on the merits of having an independent central bank (Lastra, 2015[4]). In the late 1970s, a number of studies examined the empirical relationship between central bank independence and inflation, of which the experience of the German Bundesbank and its high level of independence was considered to be instructive. This research, in particular involving the development of a central bank independence index, convinced policy makers globally on the benefit of central bank independence and this has become a standard policy recommendation made through the IMF/World Bank Financial Sector Assessment Program and OECD accession process since the 1990s.
To avoid the negative outcomes mentioned, de jure independence of central banks, where the operation of monetary policy is determined by professionals, should be underpinned by provisions in constitutions and/or primary legislation (Lybek, 2005[5]).3 Acceptance of the model as an international standard has been helped by widespread adoption of flexible inflation-targeting frameworks since the early 1990s (Ciżkowicz-Pękała et al., 2019[6]; Bordo, 2007[7]).4
Autonomy in monetary policy conduct essentially means that the central bank sets and implements policy to achieve its mandate without interference from the government. However, it is essential to distinguish between goal independence – when a central bank is free to determine its policy objectives independently – and instrument independence – when a central bank determines its operational means independently (Debelle and Fischer, 1994[8]).
Under the inflation-targeting framework currently adopted by many central banks, the implementation of policy instruments such as changes in interest rates and unconventional policy measures – including large-scale purchases of government bonds – is left to the monetary authorities, but the power to set goals is not always granted to central banks.5 In some cases, broad goals (such as price stability and full employment) are established in constitutions or primary legislation, but the central bank determines operational targets that it considers to be consistent with those goals. Central bank governors and monetary policy committees are responsible, either explicitly or implicitly, for achieving the operational targets as well as the broad goals.
De jure independence is a necessary but not sufficient condition for independent monetary policy. Without strong institutions and well-functioning democratic political systems, clear legal provisions are not enough to prevent political attempts to influence central bank decisions (Binder, 2021[9]; Balls, E. et al., 2018[10]).6 Ensuring that central banks have clear objectives, appropriate tools and competencies to meet these objectives, and that they are accountable for their actions, all contribute positively to their independence (King, 2006[11]).
Overview of legal frameworks in the benchmark countries
Countries with a civil law tradition sometimes have constitutional provisions for the central bank, but such provisions are generally not used in common law countries (BIS, 2009[12]).7 Common law countries, including Australia, India, New Zealand and the United States, do not have any central bank-related provisions in their constitutions (Table 8.1), while such provisions are present in some of the other benchmark countries. In the euro area, the Treaty on the Functioning of the European Union (TFEU) sets fundamental principles of the European System of Central Banks and the European Central Bank (Amicorum and Garavelli, 2005[13]).8
Constitutional provisions are usually broad, leaving it to primary legislation to clarify the details. The overall strength of central bank independence depends on the provisions for mandates, functions and governance rules. All countries have primary legislation to regulate the specific roles and functions of central banks.
In most countries, governments formally own central banks, like any other public institution, without any prejudice to central bank instrument independence (Bholat and Gutierrez, 2019[14]).9 In some countries, central banks are incorporated as companies with partial or total ownership by private sector shareholders, but they are still responsible for delivering public goods related to price and financial stability, as stated in their statutory mandates, rather than pursuing profits for shareholders. In Switzerland and Turkey, both the government and private shareholders own the central bank in roughly equal proportions, although both are established as special statute joint stock companies, with specific central bank laws dictating their operations and preventing private shareholders’ involvement in policy making. In the United States, commercial banks that are members of the Federal Reserve System hold stocks in their Reserve district bank, but the Federal Reserve System is considered not to be “owned” by anyone.10 The ECB is owned by the national central banks of EU countries,11 according to the capital key based on population and GDP. Most of EU national central banks are fully owned by the state with the exception of those in Belgium, Greece and Italy, which are partly owned by private sector shareholders.
Constitutional provisions related to central bank independence are in general less susceptible to amendments compared with primary legislation, consolidating de jure central bank independence. However, they may make adjustments to certain aspects of central bank autonomy, which could sometimes be required due to changing, more difficult economic circumstances. In addition, the frequently abstract nature of the provisions contained in the constitution may not be enough to ensure independence.
All public entities are subject to certain governance-related requirements in the execution of their responsibilities, but unlike other public institutions central banks may have conflicts of interest with governments over the conduct of monetary policy. From this point of view, the essential issue is whether the government can unilaterally dismiss and appoint the governor (and policy board members) without parliamentary or other approval.12
While the mandates and responsibilities of central banks in the benchmark countries are comparable, the degree of central bank independence in terms of appointment and termination provisions varies (Table 8.2). Other aspects such as the qualification criteria required for their appointment are discussed below.
Mandate and responsibility
All of the benchmark countries identify price stability or stability of purchasing power as the primary mandate, with some central banks having additional objectives such as currency and financial stability or ensuring maximum employment.13 To fulfil these mandates, central banks have responsibilities to conduct monetary and prudential policies.14 In general, primary laws stipulate the specifics of the mandate and responsibilities of central banks. In Mexico, Poland, Sweden and Switzerland, these are stated explicitly in the constitution (Table 8.3). Similarly, in the euro area, these objectives are stated in TFEU.
Appointment and dismissal of central bank governors
Processes for the appointment and dismissal of governors are specified in the legal framework in almost all countries. The appointment process is intended to ensure that non-elected members of the central bank have legitimacy in carrying out their duties, and that there is a clear process and rationale for any dismissal. The framework intends to prevent arbitrary use of power by requiring the involvement of more than one governing body in such decisions. For example, Brazil, Mexico, Poland and Sweden have constitutional provisions about an appointment and/or dismissal of a central bank governor (Table 8.4). Similar provisions are provided in TFEU for the euro area. In the euro area and Poland, the governor’s tenure and qualification criteria for central bank executives are also prescribed in the treaty/constitution. Even though the number of countries with constitutional provisions is limited, several benchmark countries have central bank laws that prohibit the government from unilaterally appointing or dismissing central bank governors, to ensure their independence.
In a few benchmark countries, however, independence in relation to the appointment and dismissal of the central bank governor has been recently challenged by other governing bodies (Dall’Orto Mas et al., 2020[15]). In Turkey, a recent legislative change based on the Statutory Decree allows the government to shorten the tenure of the central bank governor (OECD, 2021[16]). This right has been already exercised, leading to negative market reactions.
In order to ensure monetary policy autonomy, not only the central bank governor but also members of monetary policy committees (MPC) must be protected from unilateral government appointment or dismissal, as – in most central banks – monetary policy decisions are taken by the MPC by majority vote.15
Legal frameworks and procedures for appointing members of an MPC vary across the benchmark countries (Table 8.5). In the euro area, Poland and Sweden, the MPC is explicitly mentioned in TFEU and constitutions. In Poland, qualification criteria for MPC members are also prescribed in the constitution.
The specific appointment, dismissal and terms of office of MPC are often stipulated in primary legislation. In Brazil, India, Switzerland and Turkey, the executive branch of the government appoints the members, while in other countries other stakeholders are involved in the appointment. For example, in the United States, members of the Federal Reserve Board are nominated by the president of the United States and have to be confirmed by the Senate.16 In Poland, the president of the Republic, the Sejm (lower house of the country’s bicameral parliament) and the Senate each appoint three members of the MPC.
In most benchmark countries, the tenures of MPC members are in practice staggered. This arrangement provides stability of policy implementation, and prevents any given administration from appointing/dismissing several members and having political sway over monetary policy. In Costa Rica, Mexico and the United States, the mechanism of staggered tenures is enshrined in their constitutions.
Accountability
Since an independent central bank is not an elected body yet has sweeping economic powers, in a democratic society it should be accountable to lawmakers and public. The key issue is to strike the right balance between independence and accountability. On the one hand, central banks need independence, since the best policy for the economy may not be aligned with the political goals of governments. On the other hand, in fulfilling their mandate, central banks must be accountable to society through their elected representatives. There is no best compromise between these principles. While every country aims to balance independence and accountability, solutions differ among countries (Van den Berg, 2018[18]).
In some benchmark countries, legal frameworks for central bank accountability are specified in the constitution or an international treaty (Table 8.6). For instance, in Poland the constitution stipulates that the central bank shall be accountable to the Sejm and it must present monetary policy objectives every year. The Sejm can only be informed; it cannot give instructions to the central bank. In Switzerland the central bank shall be administered with the co-operation and under the supervision of the Confederation. The ECB president is legally required to submit reports annually to both the European parliament and the European Council, and the Chair of the US Federal Reserve is required to give a semi-annual testimony to Congress.
An important aspect of central bank accountability is transparency, which involves public press conferences, publication of minutes of meetings, and responding to inquiries beneficial to the public (Adrian and Khan, 2019[1]) (IMF, 2019[19]). As such, central bank transparency contributes to de facto accountability, and accountability and transparency are closely related in central bank legal frameworks. A high degree of transparency and accountability, and a well-defined and narrow mandate anchored in a strong institutional setting, help to maintain central bank independence (Mersch, 2019[20]).
Although the provisions concerning monetary policy autonomy are abstract and broad, they can directly or indirectly affect monetary policy implementation (Table 8.7). Brazil, the euro area, Mexico, Poland, Sweden and Switzerland have constitutional/treaty provisions that grant the central bank exclusive rights to issue currency.17 The central bank’s monopoly on currency is the basis of its ability to control the growth of the monetary base.18 As it is fundamental to the implementation of monetary policy, central banks in all benchmark countries have the statutory authority to issue currency, even if there is no provision in the constitution/treaty.19
The euro area and Sweden have provisions that prohibit other bodies from seeking to influence the central bank, and prohibits the central bank from taking instructions from others.
Provisions in Costa Rica, the euro area, Mexico and Switzerland ensure central bank independence directly by including the words “autonomy” or “independence” in their constitutions. Brazil and Turkey have similar provisions in their central bank laws.
In most benchmark countries, primary legislation prevents central banks from financing government expenditure or purchasing debt directly from the government. In Brazil, the euro area, Mexico and Poland, such restrictions are stated in the constitution.20
Monetary policy operations, including inflation targeting and unconventional monetary instruments, are usually not based on primary legislation or in a broad context. The policy goals are often set in accordance with agreements with or instructions from governments, but the choice of how to operate is left to the central bank. This is because central banks need to be agile and flexible in their policy implementation, in response to changes in financial and economic conditions.
Constitutional provisions on central bank independence vary across countries (Figure 8.1). A constitutional provision would ensure stronger legal protection in general, but some central banks, such as the Federal Reserve System in the United States, do not have constitutional provisions yet enjoy sufficient independence under primary law. Thus, the need for a constitutional provision should be considered in the context of the country’s history and legal system.
Key legal provisions governing the independence of the central bank should include a well-defined mandate to attain and maintain price stability; the process for appointing and dismissing senior officials and protecting them from unilateral government action; the role and operation of the monetary policy committee and the autonomy of its decisions; and a high degree of accountability and transparency to the government and the public.
References
[1] Adrian, T. and A. Khan (2019), Central Bank Accountability, Independence, and Transparency, IMF (blog).
[13] Amicorum, L. and P. Garavelli (2005), Legal Aspects of the European System of Central Banks, European Central Bank.
[10] Balls, E. et al. (2018), “Central Bank Independence Revisited: After the Financial Crisis, What should a Model Central Bank Look Like?”, M-RCBG Associate Working Paper Series, Harvard Kennedy School.
[14] Bholat, D. and K. Gutierrez (2019), “The ownership of central banks”, Bank Underground, Bank of England.
[9] Binder, C. (2021), “Political Pressure on Central Banks”, Journal of Money, Credit and Banking, https://doi.org/10.1111/jmcb.12772.
[21] BIS (2020), “Central Bank Digital Currencies: Foundational Principles and Core Features”, Joint report by The Bank of Canada, European Central Bank, Bank of Japan, Sveriges Riksbank, Swiss National Bank, Bank of England, Board of Governors of the Federal.
[17] BIS (2019), “MC Compendium: Monetary Policy Frameworks and Central Bank Market Operations”, Markets Committee Papers, Bank for International Settlements.
[12] BIS (2009), Issues in the Governance of Central Banks, Bank for Ìnternational Settlements.
[7] Bordo, M. (2007), “A Brief History of Central Banks”, Economic Commentary, Federal Reserve Bank of Cleveland.
[6] Ciżkowicz-Pękała, W. et al. (2019), “Three Decades of Inflation Targeting”, NBP Working Paper 314.
[15] Dall’Orto Mas, R. et al. (2020), “The Case for Central Bank Independence: A review of Key Issues in the International Debate”, ECB Occasional Paper Series, European Central Bank.
[8] Debelle, G. and S. Fischer (1994), “How Independent Should a Central Bank Be?”, in Goals, Guidelines, and Constraints Facing Monetary Policymakers, Federal Reserve Bank of Boston.
[19] IMF (2019), Staff Proposal to Update the Monetary and Financial Policies Transparency Code, IMF Policy Paper.
[11] King, M. (2006), “Trusting in Money: From Kirkcaldy to the MPC”, Speech by Mr Mervyn King, Governor of the Bank of England, delivering the Adam Smith Lecture 2006, St Bryce Kirk, Kirkcaldy, Scotland, 29 October 2006.
[4] Lastra, R. (2015), International Financial and Monetary Law, Oxford University Press.
[5] Lybek, T. (2005), “Central Bank Autonomy, Accountability, and Governance: Conceptual Framework”, Current Developments in Monetary and Financial Law International, Vol. 4.
[20] Mersch, Y. (2019), International Trends in Central Bank Independence: the ECB’s Perspective.
[16] OECD (2021), OECD Economic Surveys: Turkey 2021, OECD Publishing, Paris, https://dx.doi.org/10.1787/2cd09ab1-en.
[3] Sargent, T. (1982), “The Ends of Four Big Inflations”, in Hall, R. (ed.), Inflation: Causes and Effects, University of Chicago Press, http://www.nber.org/chapters/c11452.
[18] Van den Berg, R. (2018), Balancing the Independence and Accountability of the Bank of Canada, Library of Parliament, Canada.
[2] Weidmann, J. (2019), The Role of the Central Bank in a Modern Economy - a European Perspective.
Notes
← 1. The Swedish Riksbank was established in 1668 as a joint stock bank to lend the government funds and to act as a clearing house for commerce. In 1694, the Bank of England was founded also as a joint stock company to purchase government debt. Other central banks in Europe were set up later for similar purposes, though some were established to deal with monetary disarray. The Federal Reserve System was created by the US Congress in 1913 as the nation's central bank in which commercial banks hold stock with the aim to provide a safer, more flexible and more stable monetary and financial system.
← 2. For example, Sargent (1982[3]) describes the historical experiences of hyperinflation in Austria, Hungary, Germany and Poland in the 1920s, stressing that the creation of an independent central bank – that was legally prohibited from extending unsecured credit to government – would have been one of the essential measures to prevent such hyperinflation. In the past decade, Zimbabwe has experienced hyperinflation fuelled by the central bank printing money.
← 3. “
← 4. Bordo (2007[7]) provides a brief history of central banks, including the transition to independence.
← 5. In some countries (e.g. Australia, India, New Zealand and Turkey) the government is involved in determining policy objectives, including the target inflation rate.
← 6. Based on a sample of 118 central banks between 2010 and 2018, Binder (2021[9]) illustrated that on average about 10% of these banks reportedly face political pressure every year.
← 7. The civil law system is based on the codification of the core principles of laws, whereas the common law system derives from uncodified judge-made case law, which gives precedential authority to prior court decisions.
← 8. With the establishment of the ECB, national central banks in the euro area countries no longer set monetary policy but they continue to maintain many important functions. Such changes were brought about by the ratification of TFEU. For further details on the legal framework of the European System of Central Banks and the ECB, see Amicorum and Garavelli (2005[13]).
← 9. The owners of central banks are responsible for making executive appointments, and receive a share of central banks’ profits, while the banks’ senior management and policy committees are responsible for controlling daily operations and the conduct of monetary policy.
← 10. For details see the FAQ prepared by the Federal Reserve: www.federalreserve.gov/faqs/about_14986.htm.
← 11. Central banks from EU countries that are not members of the monetary union do not participate in the ECB policy-making body (governing council).
← 12. The principle of independence of the central bank from the government has much in common with the principle of the independence of the judiciary. See the commentary on the constitutional court in Chapter 5.
← 13. Central banks in the euro area, Mexico, New Zealand, Switzerland and Turkey have price stability as their most important mandate. In the other economies, each mandate is regarded as being of equal importance.
← 14. Prudential policies consist of micro- and macro-prudential policies. Micro-prudential policies aim at protecting individual financial institutions from idiosyncratic risks and encouraging sound management. The objective of macro-prudential policies is to ensure the stability of the financial system as a whole, by taking into account interactions among financial institutions as well as the feedback loops of the financial sector with the real economy. Examples of prudential regulation include minimum required liquidity and capital ratios, and caps on loans in relation to the value of purchased property or to income. In almost all countries the central bank is responsible for macro-prudential policies, and in some countries also for micro-prudential policies, in co-ordination with the financial supervisory authority.
← 15. On most monetary policy boards, the chairperson has a casting vote when votes for and against are in equal numbers.
← 16. In the Unites States, the policy-making Federal Open Market Committee (FOMC) consists of seven governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve District Bank presidents. The US president’s nomination and Senate’s confirmation processes are required only for the seven governors of the Federal Reserve Board.
← 17. According to the constitution of Costa Rica, the Legislative Assembly has sole powers to establish the law on the unit of currency and enact laws on currency, credit, weights and measures (Article 121). However, there are no relevant provisions on the central bank's right to issue currency.
← 18. Central banks have an ability to manipulate the monetary base during the conduct of monetary policy. The monetary base is the total amount of currency in circulation plus commercial bank deposits held as the central bank's reserves.
← 19. Future possible implementation of central bank digital currencies, which are under considerations in several countries, would require new legal provisions on currency issuance (BIS, 2020[21]).
← 20. The United States guarantees monetary policy autonomy by permitting the Federal Reserve to purchase government debt only in the secondary market. The other countries, such as Costa Rica, Switzerland and Turkey, have similar provisions in their primary legislation.