Central Bank independence- lessons from BoE and Fed history

Michael Bordo writes a very timely paper on the topic. He revisits history of Bank of England and Fed to understand lessons on Central Bank Independence in this crisis.  Fed was a relatively more independent central bank to begin with.  He draws following lessons:

First, central bank independence can be helpful in dealing with financial crises. This was the case in Western Europe during the classical gold standard era. The Bank of England and its counterparts in Western Europe as publicly chartered banks of issue , effectively maintained a credible nominal anchor and served as an effective lender of last resort to the financial system. They operated in a rules based regime.

Second, based on the experience of the Federal Reserve in the interwar period, central bank independence can be harmful if it is based on a flawed policy doctrine or a structurally flawed institution

Third, serious financial crises can compromise central bank independence. This was the case with the Bank of England in the crisis of 1797 and especially during the recent crisis where the Fed has lost much of its independence and will need to struggle to regain it. It is an open question whether the Fed needed to abandon its “Treasuries Only “ policy and purchase long-term Treasuries and mortgage backed securities, whether it needed to follow credit policy and engage in credit allocation, whether it needed to bail out non bank financial institutions or to follow the “Too big( and too interconnected) to fail” doctrine? Or whether a different approach to the crisis could have preserved its independence and hence assured its credibility for low inflation ( Wheelock 2010).

One possibility would have been for it to follow highly expansionary monetary policy from August 2007 throughout 2008 (the Fed held policy too tight through much of 2008  hence aggravating the downturn (Hetzel 2009)), and let the Treasury deal with all the bailouts and selective credit allocations by itself. Likely the Fed would have hit the zero nominal bound in 2008 and would have had to engage in quantitative easing involving the purchase at least of long-term Treasuries to attenuate the recession . Thus in the end it might have not been possible for the Fed to completely separate itself from fiscal policy actions but it may have gone a lot farther than it did in that direction.


There is an interesting bit of information regarding Fed’s independence in Great Depression. The story is whenever Fed exercised independence, the economy plunged!

In the 1920s the Fed carried out an independent monetary policy based on the Burgess Rieffler doctrine — a variant of the real bills doctrine—(Meltzer 2003) in what Friedman and Schwartz ( 1963) termed “ The High Tide of the Federal Reserve”. But then its flawed real bills perception of the stock market boom (as a harbinger of inflation) led it to tighten policy to kill the boom triggering a recession in August 1929 and the Wall Street crash in October

In reaction to the Great Contraction the Fed was reorganized in the Bank Acts of 1933 and 1935. In theory the 1935 Act solidified the Fed’s independence by removing the Secretary of the Treasury and the Comptroller of the Currency from the Federal Reserve Board and centralizing control in the new Board of Governors. However as Meltzer ( 2003) points out, although the Fed in theory had the trappings of a powerful central bank(“Independent within the government”) in practice it was subservient to Treasury gold policy and a low interest rate peg from the mid 1930s to 1951. The one episode when the Fed used its policy independence was in 1936-37, when it doubled reserve requirements in a mistaken attempt to mop us excess reserves in the commercial banking system. This action led to a serious recession in 1937-38.

🙂 (Emphasis is mine)

Though this does not imply CBI is not important. It is just to show how Fed messed up in great depression.

One Response to “Central Bank independence- lessons from BoE and Fed history”

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