Central banks should be independent of government. But our research shows they are under political pressure

All includes up to 138 central banks with available financial statements. Large CB includes the Federal Reserve, the ECB, the Bank of England, the Bank of Japan, Deutsche Bundesbank, and the Bank of Canada. Developed includes central banks from developed countries based on the United Nations classification. Eurozone includes central banks from Eurozone countries. Author provided (no reuse)

However, during the 2008 financial crisis and the COVID pandemic, central banks had bought assets such as government bonds to inject money into their economies and stimulate spending, a process known as quantitative easing (QE). But as interest rates began to rise, the value of these assets — acquired when rates were lower — declined^[4].

Central banks had turned to QE to encourage spending because they could no longer lower interest rates, which had hit zero^[5]. But when the bonds fell in value and central bank interest expenses began increasing, central banks started incurring losses.

For future crises, central banks will have to evaluate the effectiveness of QE. But their losses should be viewed as part of the cost of managing economic crises and not as a sign of failure.

A central bank’s effectiveness hinges on its independence. History shows that political interference^[6] can be disastrous, as politicians resist central bank losses. They do this because central bank profits often support government budgets, reducing the need for unpopular tax hikes.

For example, in Argentina^[7] and Turkey, political pressure on central banks to finance budget deficits has resulted in poor policy decisions, leading to repeated bouts of runaway inflation and prolonged economic instability.

Politicians also tend to favour low interest rates to stimulate the economy and get consumers spending. However, low rates can encourage excessive debt in both the private sector and government. For example, keeping interest rates low despite rising inflation has led to skyrocketing house prices in Turkey^[8], and exacerbated its cost of living crisis.

When circumstances change — say, the need to raise rates to combat inflation — excessive debt can increase vulnerability to shocks, such as the COVID pandemic and the war in Ukraine.

To achieve stability, central banks must be free to incur accounting losses when necessary, and they need politicians to accept that losses can be a reasonable way of dealing with economic circumstances.

Our research^[9], provides systematic evidence that central banks are uncomfortable reporting losses. Analysing financial statements from central banks in 155 countries over 23 years, we found they are significantly more likely to report slightly positive profits than slightly negative losses.

This tendency to avoid losses mirrors the behaviour^[10] of commercial banks and corporations that “manage” their reported earnings to meet or beat targets.

Importantly, our findings suggest that central banks under pressure — particularly those facing extreme (right- or left-wing) leaders — are 19 times more likely to report small profits than small losses. This likelihood drops to four times under centrist leaders.

Additionally, central banks with governors that can be reappointed at the end of their term are more than seven times more likely to report small profits, compared to those with non-reappointable governors, who are only twice as likely.

And as we show, central banks that “bunch” just above the zero-profit threshold tend to maintain lower interest rates than would be expected by the inflation rate. They achieve systematically higher inflation rates.

While this does not prove that political interference is distorting central bank policies, it indicates that their incentives to avoid losses correlate with their policy choices and inflation outcomes, as well as government leanings and the governor’s chances of a renewed term. Another interpretation is that incentives to avoid reporting losses are stronger when inflation rates are above target.

Importantly though, both interpretations indicate that central banks may not be as independent as you might think.

Why does this matter now? For one, the actual losses central banks face may be even larger than in the graph above. Our research shows that central banks often use accounting techniques to manage their reported profits, effectively hiding the true extent of losses.

Chair of the US Federal Reserve Jerome Powell has warned against political pressure on central banks. Domenico Fornas/Shutterstock^[11]

Hidden losses indicate that central banks are under external pressure — often political — to minimise accounting deficits.

This pressure can lead to bad policies, such as prematurely lowering interest rates to reduce central bank losses and supporting government budgets by lowering debt servicing costs.

However, this could backfire by causing inflation to surge. So understanding, and accepting there could be losses, as well as addressing hidden pressures on central banks is crucial for ensuring they can make the tough decisions necessary for long-term economic stability.

Politicians and the media share responsibility for the climate in which central banks operate, and their responses to losses often determine how central banks will act in future.

Importantly, central banks must remain financially independent so they have the resources to respond to crises and can act immediately without having to go cap in hand to their government.

Read more https://theconversation.com/central-banks-should-be-independent-of-government-but-our-research-shows-they-are-under-political-pressure-238466

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