A lesson from emerging markets: Why central bank independence is so important

Jerome Powell, chair of the US central bank, the Federal Reserve, often reminds us that “without price stability, the economy does not work for anyone”. Indeed, when people don’t have to worry about their money losing value, entrepreneurship and job creation can flourish.

Price stability has been seriously tested in recent years. The COVID-19 pandemic negatively impacted global trade and supply chains, sending the price of all kinds of goods rocketing. At the same time, government stimulus measures of colossal proportions unleashed sharply higher demand for goods and services, which also helped to push up prices.

Since then, rising geopolitical tensions have led to growing fragmentation, with the cross-border flow of goods and services facing greater limitations. Inflationary pressures in most of the world have remained elevated as a result, and these pressures look unlikely to fully dissipate any time soon.

Independent central banks that are able to conduct monetary policy largely free from political interference have historically demonstrated a strong ability to manage inflation. Central bank autonomy is arguably the best monetary policy governance structure ever devised, as illustrated by the experience of emerging markets in recent decades.

The genesis of central bank independence in emerging markets can be traced back to the 1970s. Very high energy prices led oil-producing countries such as Saudi Arabia and Kuwait to enjoy outsized financial surpluses, which were recycled by Western commercial banks in the form of vast loans to emerging market economies. The hangover from this party was severe as global monetary policy tightened and the global economy slowed down towards the end of that decade.

The 1980s were characterized by recurring debt restructurings in the emerging world. Many countries, including most in Latin America, were cut off from external funding and facing shallow domestic capital markets and so resorted to their central banks to finance their government deficits. A painful environment of very high inflation and depressed economic growth ensued, which has since been dubbed “the lost decade”.

In the 1990s, emerging markets such as Mexico, Peru and Poland drastically recalibrated economic policy through a long and arduous journey of economic reform. Central to these reforms was granting autonomy to their central banks, which allowed many of them to adopt an “inflation targeting” regime. This is the practice of adjusting monetary policy to achieve a specified annual rate of inflation.

Slowly but surely, these economies experienced a stark economic and financial transformation. So much so that, during the most recent global inflation spike, many emerging market central banks led the way when it came to adjusting monetary policy. Central banks in countries such as Brazil, Hungary and Chile first tightened and later eased monetary policy well ahead of the US Federal Reserve and the European Central Bank.

Conversely, emerging markets that subjected their central banks to political interference have fared much worse. Hyperinflation and economic stagnation have plagued countries like Argentina and Venezuela during the same period, as their governments repeatedly directed central banks to print money to finance outsized fiscal spending over the last two decades.

More recently, the Brazilian Central Bank has been thrust into the political spotlight by its country’s politicians. It has enjoyed enhanced independence since 2021 and has been able to handle inflationary pressures well. But it has come under increased political pressure lately to deepen interest rate cuts in order to boost domestic economic activity.

And even beyond emerging markets, there have been particularly concerning reports that the independence of the Federal Reserve is being questioned in an electorally charged year in the US. The US dollar and US financial markets remain the bedrock of the global financial system; any sudden loss of confidence in them would inflict severe economic and financial pain worldwide.

Keeping all of these experiences top of mind today is crucial. The risk of government influence has increased as most central banks face near-term tradeoffs between achieving price stability and supporting economic activity. Credibility around central bank independence can take decades to build and, like anything involving trust, can be lost overnight.