Remarks by Governor Gabriel Makhlouf at Les Rencontres Économiques d'Aix-en-Provence

Central Bank Independence is a Political Question

Thank you for the opportunity to discuss a question that strikes at the very core of modern governance. It is really about what role the central bank should occupy in the regulatory state.  

And it is not a technocratic question. The delegation of certain key aspects of economic policy, monetary policy, financial stability and financial regulation in the case of both the ECB and the Central Bank of Ireland, is a fundamental issue and a challenging task for any democracy. Delegating power to a trusted and independent, but unelected authority such as the central bank raises obvious issues related to accountability and representation.¹

We must not forget the conditions under which central banks came to have their current special and unique role within the key institutions of a country.

It was only following the high inflation that the world experienced from the late 1960s to the 1980s, and the failure of many governments to deal with it, that the central banks of most advanced economies were granted independent monetary policy powers to first achieve and then maintain stable prices.

Delegating the conduct of monetary policy to an independent and external authority, such as the central bank, therefore, reflected the need to resolve time inconsistency problems and overcome the so-called “inflation bias” that governments were facing.²

Central banks are assigned powerful tools, but to be used under mandates: mandates most often centred on ensuring price stability, and in some cases, such as that of the Federal Reserve in the United States, also including supporting maximum employment.

In the case of the ECB Governing Council, the mandate is stated in the Treaty on the Functioning of the European Union. Article 127 states that the primary objective of the Eurosystem is to maintain price stability. “Without prejudice” to its price stability objective, the ECB is mandated to support the general economic policies of the Union.

I believe that the clarity of the mandate of the ECB, which provides the central bank with exclusive and primary responsibility for maintaining price stability, with a supporting and conditional role for the other economic objectives of the Union, strikes the right balance between optimal delegation and accountability.

Indeed, the tension between the power of an independent but unelected authority and its accountability, can be resolved thanks to the clarity of the mandate it is assigned, and the fact that its focus is not too wide.

More broadly, any delegated policy regime must be structured around clear and shared objectives, which can serve as a firm anchor for accountability; procedural constraints by themselves may be insufficient.

In the case of monetary policy, it is essential that the central bank develops and maintains the ability to communicate effectively and transparently to the people it serves. 

Central bankers are assigned with a crucial task for the wellbeing of our citizens. As I’ve said in the past, our success requires that we are held accountable for our choices and that our conduct is transparent. Only by keeping the trust of the public we serve, central banks can ultimately retain their autonomy and effectiveness.³

A strategy to fulfil our mandate

Back to the mandate, the ECB’s is clear but the Treaty does not spell out a quantitative definition for what “price stability” means. Therefore, it is up to the Governing Council to set out an appropriate strategy to achieve the primary objective of maintaining stable prices.

In our 2021 review, the Governing Council replaced the previous inflation target of “below, but close to 2%” with a clear, symmetric 2% target. The reason for this revision, which we have retained following the most recent review, was to remove any ambiguity about what level of inflation we aim at achieving in the medium term. By doing so, our goal was also to anchor inflation expectation more firmly on our inflation target.⁴

Following the conclusion of the 2021 strategy review, a series of unprecedented shocks pushed inflation up to levels that our economies had not experienced for many decades. This was perhaps the most arduous test imaginable for our revised strategy. Despite the initial inflation surge, however, measures of longer-term inflation expectations remained well anchored at our 2% target. In other words, markets, households and firms trusted our ability to tackle these unprecedented inflationary shocks and, within a reasonable time span, to bring back inflation to levels consistent with our target.

Our price stability mandate, and our clear 2% inflation target, bolstered by a forceful monetary policy tightening – were instrumental to keep the trust of the private sector and long term expectations anchored.

In the absence of this trust, second round effects would have certainly extended the period of high inflation much further. And this would have in turn required a much stronger monetary tightening, and over a longer period of time, with the concrete risk of increasing unemployment and triggering a recession.⁵

Periodic strategy reviews, and on Monday we announced the conclusions of  our 2025  review, are an opportunity to reflect on our strategy.⁶ One of the main conclusions that we reached over the course of our latest review is that our clear, symmetric 2% target has served us well since we introduced it four years ago. The 2% target has proved an important anchor, and not only for the expectations of households and firms. I would say that it helped us in the Governing Council to more effectively come to decisions, removing a layer of potential disagreement on the exact quantification of our inflation objective.  Where the 2021 strategy emphasised de-anchoring from below – unsurprisingly, give the low-flation experience of the preceding decade, the 2025 strategy stresses the “importance of appropriately forceful or persistent monetary policy action in response to large, sustained deviations of inflation from the target in either direction, to avoid deviations becoming entrenched through de-anchored inflation expectations.” 

Since the last review, the world economy has experienced, and continues to experience, important changes, some of which are of a structural nature. This has greatly affected the inflation environment, making it less predictable and more volatile, so adding to the challenges of monetary policymaking. This prompted another alteration to our strategy: a greater role for scenario and sensitivity analysis when assessing the risks around the most likely path for inflation.  This reflects that, in times of elevated uncertainty or volatility, the Governing Council needs to carry out an integrated assessment of all the relevant factors that shape the inflation outlook, including the scale and scope of the risks to the baseline inflation forecasts.

The financial stability mandate

I’ve focused on inflation so far, and indeed, prior to the financial crisis, the dominant mandate of many central banks was price stability. However, as the lessons of the financial crisis were absorbed, the financial stability mandate grew in prominence.

One of the key outcomes of our 2021 strategy review was a recognition of the interdependence of price stability and financial stability, with central banks unable to deliver the former unless achieving and maintaining the latter.  Therefore, we decided to enhance the analytical framework on which we base our monetary policy deliberations, to account for the inherent links between price and financial stability.⁷

This greater integration acknowledges, as was well-known prior to that review, that monetary policy tools are not the best suited to guaranteeing financial stability.⁸ Instead, central banks with financial stability mandates gained new macroprudential powers to address financial stability risks.⁹

Here in Ireland, we have seen our financial stability mandate evolve in line with the expanding role of the domestic financial system.

In the post crisis period, the Central Bank was given microprudential responsibilities, followed by macroprudential responsibilities for banks and borrowers, and most recently with the expansion of non-bank financial intermediation within the Irish financial system and the development of our macroprudential framework for non-banks.

In a similar manner, the ECB’s mandate has expanded in the post crisis period and under the SSM Regulation, the ECB is mandated to contribute to the smooth conduct of policies pursued by the competent authorities relating to prudential supervision and financial stability.¹⁰

As I have discussed in the past,¹¹ the interaction between price and financial stability mandates is complex. And this holds also for the microprudential mandate too.

The financial system transmits monetary policy to households, firms and governments and, therefore, a well-functioning and stable financial system helps monetary policy to work better. In fact, financial stability is a pre-condition for price stability, and vice versa.

But there are times when there may be tensions between these mandates, for example at times of unconventional measures such as asset purchases and negative rates. The aim of such purchases is to ensure that prices do not enter a deflationary cycle. However, this can also create conditions which in the past have been conducive to unsustainable borrowing and ‘search for yield’ behaviour in financial markets.

At times like these, macroprudential policy is the first line of defence for financial stability, and macroprudential instruments can be deployed in a selective and targeted way to address financial stability risks.

Coming back for a moment to the importance of accountability and transparency in a delegated policy regime, there is a challenge here arising from the different levels of maturity in the framework for financial stability compared to that of monetary policy.

The objective for monetary policy has evolved over time, as already discussed, and we are now at a point where we at the ECB have a quantitative objective and a defined set of tools to achieve that objective.

On the other hand, macroprudential policy is at a much earlier stage in its development, with no single definition of financial stability, and as the key variables for capturing systemic risk continue to evolve.

We are certainly not at the stage yet where we have a quantitative objective for financial stability and this gives rise to accountability challenges and puts even more importance on the need for transparency and communication by the authority on its policy framework and actions.

In Ireland, as a small open economy in a monetary union, macroprudential policy has particular importance. The approach we have taken in building our macroprudential framework from the outset is that we must build resilience in our financial system against different risk factors and to mitigate pro-cyclicality in a downturn, in the context of the inherent volatility of the Irish macro-financial environment.

Our approach at all times with these policies is to articulate clear objectives for each macroprudential policy action, to support our decision-making with a credible body of research and analysis, and to seek the views of our stakeholders through public consultations, surveys, and conferences. And of course, to publish all of these inputs for maximum transparency.

These policies may not always be popular with affected stakeholders, and this challenges us further to support our policies with strong evidence, including on the costs as well as the benefits of a particular policy, and to explain our policy decisions very clearly. But this brings me back to the importance of independence and also to the importance of trust in a delegated policy regime.  

While we have not yet gone through a full financial cycle that will allow us to judge the success or otherwise of our macroprudential policies, we were able to draw some comfort from the resilience of the banking and household sectors during the Covid shock, albeit that the widespread fiscal support means that care needs to be taken in drawing too much from this episode.

But we continually assess the resilience of the domestic financial system, in the context of the risks facing that system, to ensure that our macroprudential policy settings remain appropriate. 

Conclusion

To conclude, central banks are important institutions of the state.  The role they hold, the responsibilities they are given, the powers they are granted, all of these are primarily issues for society to decide.  In advanced democracies, they are, in effect, political questions to be decided by due process, involving discussion and debate. 

The second half of the twentieth century saw the consensus settle in favour of granting central banks independence in monetary policy and also in their financial stability and regulatory policy roles.  In my view the evidence points to that conclusion being the correct one and has benefited societies and enhanced their welfare compared to the counterfactual.

But, as Francis Fukuyama has pointed out, political institutions “develop often painfully and slowly over time, as human societies strive to organise themselves to master their environments [and] political decay occurs when political systems fail to adjust to changing circumstances.”¹² We need to be humble and recognise that changing circumstances may mean that a new consensus around the role of central banks is needed.  And if indeed any new political settlement leads to different mandates resting within a central bank, it is vital that there are clear objectives for each policy, a clear set of tools that are to be used to address these policies, and clear and accountable governance structures in place to guide decision-making.

But, for my part, the case for the current consensus, and mandating independent central banks to pursue price and financial stability, remains as strong as ever, and central banks should continue to resist interference that seeks to undermine the political settlement that gave them independence in the first place.  Expanding the central bank’s role too far risks diluting its focus. Accountability needs a firm anchor, built on clear and shared objectives; excessive mandate expansions would certainly weaken it and risk undermining the central bank’s credibility.

I believe that our timely, strong and effective response to the inflationary shocks in the post-pandemic period shows that the mandate given us by the EU Treaty strikes the right balance.  And I also believe that our strong and active macroprudential policy to build financial sector resilience in the post-crisis Ireland also supports the financial stability mandate of the Central Bank of Ireland.