Central bank independence
Based on Wikipedia: Central bank independence
In the summer of 2025, reports emerged that President Donald Trump had drafted a letter to fire Jerome Powell, the chair of the Federal Reserve. Trump later denied it, but the incident illuminated something most people rarely think about: why can't the president just fire the person who controls interest rates?
The answer lies in one of the most consequential but least understood features of modern economies—central bank independence.
The Problem Independence Was Designed to Solve
Imagine you're a politician facing re-election in six months. The economy is sluggish, unemployment is creeping up, and voters are unhappy. You have access to someone who could, with a few keystrokes, lower interest rates, make borrowing cheaper, and stimulate a short-term economic boom. The temptation would be overwhelming.
This is the fundamental tension at the heart of monetary policy. What's good for winning the next election is often terrible for long-term economic health.
Lower interest rates can juice an economy in the short run, but if overdone, they lead to inflation—the silent tax that erodes everyone's purchasing power. Politicians, by nature, think in election cycles. Economies, by nature, operate on much longer timescales. This mismatch creates a persistent pressure toward policies that feel good now but cause pain later.
Central bank independence is the institutional solution to this problem. By insulating the people who control interest rates from the people who control elections, modern democracies attempt to remove monetary policy from the electoral calendar.
A Brief History of Letting Go
The idea that monetary authorities should operate at arm's length from politicians emerged from the chaos following World War I. The Brussels International Financial Conference of 1920—a gathering that sounds almost comically bureaucratic today—laid the theoretical groundwork for independent central banking. The delegates had witnessed firsthand how wartime governments, desperate for funds, had manipulated currencies and printing presses with disastrous results.
But theory is one thing. Practice took longer.
In the United States, the Federal Reserve spent its first few decades under the thumb of the Treasury Department. During World War II, the Fed essentially functioned as a financing arm of the government, keeping interest rates artificially low to make war debt cheaper. This arrangement persisted even after the war ended.
The turning point came in 1951, with an agreement known simply as "the Accord." The Federal Reserve and the Treasury Department formally agreed that the Fed would no longer be obligated to support government bond prices. For the first time, America's central bank could pursue its own monetary policy objectives without direct government interference.
It was a quiet revolution.
The Great Inflation and Its Lessons
Despite the 1951 Accord, central bank independence remained more theory than practice for decades. The 1970s changed everything.
Inflation during that decade reached levels that seem almost unimaginable today. In the United States, prices rose by more than 13 percent in a single year. The culprit, economists later concluded, was partly political pressure on the Federal Reserve. Presidents Nixon and Ford both leaned on Fed chairs to keep interest rates low, even as inflation spiraled.
The experience was searing. A generation of economists, policymakers, and ordinary citizens learned viscerally what happens when monetary policy serves political masters.
Starting in the 1980s, country after country reformed their central banking laws. The movement accelerated in the 1990s. New Zealand pioneered explicit inflation targeting in 1990. The Bank of England gained operational independence in 1997. The European Central Bank, created in 1998, was designed from scratch with independence as a founding principle.
By the turn of the millennium, an independent central bank had become almost a prerequisite for being taken seriously as a modern economy.
What Independence Actually Means
Central bank independence isn't a single thing. It's a bundle of different freedoms, each protecting the institution from a different form of pressure.
Goal independence is the most fundamental: the power to set your own objectives. Can the central bank decide what inflation rate it's targeting? Can it determine how quickly it wants to reach that target? A fully goal-independent central bank answers to no one on these questions.
Instrument independence is more common. Here, politicians set the goals—say, "keep inflation around 2 percent"—but the central bank chooses how to get there. It decides whether to raise or lower interest rates, when to buy or sell bonds, whether to impose credit restrictions. The destination is assigned; the route is up to the driver.
Personal independence protects the humans who run the institution. Central bank governors and board members typically serve fixed terms, often longer than electoral cycles. They can't be fired on a whim. Dismissal requires cause—not just a president's displeasure at an inconvenient interest rate decision.
Financial independence ensures the central bank controls its own budget. An institution that must beg the legislature for funding each year is an institution that can be starved into submission.
Most central banks have some combination of these protections, but rarely all of them. The Federal Reserve, for instance, has significant instrument independence but operates under a dual mandate—price stability and full employment—set by Congress. The European Central Bank has perhaps the strongest formal independence of any major central bank, with a single mandate focused on price stability and legal protections embedded in international treaties that are nearly impossible to change.
The Architecture of Insulation
How do you build an institution that can resist political pressure? The details matter.
Terms for governors and board members are typically long—fourteen years for Federal Reserve Board members in the United States. This ensures that no single president can stack the board with loyalists. Staggered appointments reinforce this: board seats come up at different times, so even a two-term president won't appoint the entire body.
Dismissal procedures are deliberately cumbersome. In most systems, you can't fire a central bank governor simply because you disagree with their decisions. There must be cause—malfeasance, incapacity, serious misconduct. Disagreement over interest rate policy doesn't qualify.
Transparency serves as a counterweight to independence. Central banks that face no electoral accountability must demonstrate their legitimacy through other means. Most publish detailed minutes of their policy meetings, hold regular press conferences, and submit to congressional or parliamentary testimony. The Federal Reserve chair appears before Congress twice a year. European Central Bank officials face questioning from the European Parliament.
This transparency isn't just about democratic legitimacy. It also helps the central bank do its job. Monetary policy works partly through expectations. If businesses and consumers believe the central bank will keep inflation low, they'll behave accordingly—which helps the central bank keep inflation low. Clear communication builds credibility, and credibility makes policy more effective.
The Money That Banks Create
To understand why central bank independence matters, you need to understand something surprising about how money actually works.
Most people assume that central banks create most of the money in circulation. They don't. Commercial banks do.
When a commercial bank issues a loan, it doesn't hand over money from a vault. It creates new money by crediting the borrower's account. This is called fractional-reserve banking—banks keep only a fraction of their deposits on hand, lending out the rest. But "lending out" doesn't mean transferring existing money; it means creating new deposits.
This might sound like magic, and in some ways it is. The money supply expands and contracts based on commercial banks' lending decisions, which themselves depend on economic conditions, regulations, and—critically—central bank policy.
When a central bank raises interest rates, borrowing becomes more expensive, which discourages lending, which slows money creation, which cools the economy. When it lowers rates, the opposite happens. This is the transmission mechanism of monetary policy: the central bank adjusts the conditions under which commercial banks create money.
But here's where independence becomes crucial. Credit creation follows cycles that don't align with political calendars. Banks tend to lend aggressively during booms, when everything looks rosy, and pull back during busts, when they're scared. An independent central bank can implement countercyclical policies—tightening during booms and loosening during busts—even when those policies are politically unpopular.
Telling banks to cool it during an economic boom, when everyone is making money and feeling optimistic, requires the ability to ignore the inevitable political backlash. Only an institution insulated from electoral pressure can consistently do this.
The Democratic Objection
Not everyone celebrates central bank independence. There's a serious argument that it conflicts with fundamental democratic principles.
The objection goes like this: In a democracy, consequential decisions should be made by elected officials who can be held accountable by voters. Monetary policy is extraordinarily consequential—it affects employment, inflation, housing costs, the value of savings. Yet it's made by unelected technocrats who serve terms longer than most presidents.
This creates what political scientists call a "democratic deficit." Citizens who dislike monetary policy have no direct way to change it. They can vote out the president, but the Fed chair stays. They can elect new legislators, but Congress doesn't set interest rates.
Critics also point out that central bank independence isn't politically neutral. Prioritizing low inflation over low unemployment, as many independent central banks do, benefits creditors over debtors, asset holders over wage earners. The institutional setup that's presented as apolitical technocracy may actually embed a particular set of economic preferences—and not everyone's preferences are represented equally.
These objections are serious. The standard response—that independence produces better long-term outcomes that benefit everyone—may be true, but it doesn't fully answer the democratic critique. We don't generally accept "trust us, we know better" as a justification for removing other important decisions from democratic control.
The Limits of Independence
Even the most independent central bank operates within constraints.
Monetary policy and fiscal policy must ultimately work together. A central bank trying to fight inflation while the government runs massive deficits is like trying to cool a house while someone else leaves all the windows open. The 2020s have illustrated this tension vividly, as governments expanded spending dramatically while central banks tried to manage the inflationary consequences.
Political pressure doesn't disappear just because it's not supposed to exist. During economic crises, the pressure on central banks intensifies dramatically. When unemployment spikes and businesses fail, politicians—reflecting genuine public suffering—demand action. Independent central banks must navigate these pressures while maintaining their long-term focus.
There's also the question of effectiveness. Central bank independence emerged partly from the belief that monetary policy could control inflation if properly managed. The 2008 financial crisis and its aftermath complicated this picture. When interest rates hit zero, central banks found their traditional tools ineffective. They invented new ones—quantitative easing, forward guidance—but the experience revealed that monetary policy has limits, particularly during financial emergencies.
A Global Patchwork
Central bank independence exists on a spectrum, and different countries sit at different points.
The Federal Reserve represents one model: substantial independence with a dual mandate covering both price stability and full employment. This dual mandate reflects American priorities—Europeans have historically placed more emphasis on inflation, Americans more on jobs—and gives the Fed somewhat less goal independence than some of its peers.
The European Central Bank represents another model: designed from scratch with maximum independence and a primary mandate focused on price stability. The treaty provisions that govern the European Central Bank are extraordinarily difficult to change, requiring unanimous agreement among European Union member states. This makes the European Central Bank arguably the most insulated major central bank in the world.
The Bank of England represents a third model: operational independence granted relatively recently, in 1997, with clear inflation targeting responsibilities but within a framework set by the government. The British approach emphasizes that independence is a practical arrangement, not a constitutional principle—Parliament could revoke it if it chose.
And then there's the People's Bank of China, which reminds us that independence is not universal. China's central bank operates under the direction of the Chinese Communist Party. Monetary policy serves the party's economic objectives, which may include goals that an independent central bank would never pursue. This doesn't mean Chinese monetary policy is necessarily worse—that's an empirical question—but it reflects a fundamentally different philosophy about the relationship between government and the economy.
Most developing countries fall somewhere in between, with formal independence provisions that may or may not reflect actual practice.
The Future of Independence
The Trump-Powell incident, however it ultimately resolves, points to an enduring tension. Central bank independence exists because we don't trust politicians with monetary policy. But in a democracy, the people politicians represent have legitimate claims to influence economic policy. Squaring this circle is never quite finished.
New challenges keep emerging. Climate change raises questions about whether central banks should consider environmental risks in their operations. Inequality raises questions about whether price stability alone is a sufficient mandate. Digital currencies raise questions about whether central banks' monopoly on money creation will survive the century.
Each of these debates, ultimately, is about how much independence central banks should have and toward what ends it should be directed.
The original insight remains valid: short-term political incentives and long-term economic stability don't naturally align. Some institutional arrangement must mediate this tension. Central bank independence is our current best answer, even as its critics raise legitimate concerns and its limits become increasingly apparent.
What we're really debating, beneath the technical details about interest rates and mandates, is one of the oldest questions in political philosophy: how do we constrain short-term impulses in service of long-term goods? The central bank, sitting uneasily between democratic accountability and technocratic expertise, is our imperfect attempt at an answer.