Central bank independence: why does it matter, and what happens if it’s eroded?

Henrik Helsen
Nov 5
5 min read

Updated: 9 hours ago

For the purposes of this article, we will focus mostly on the United States and the Federal Reserve (the Fed), as that is where the threat to central bank independence appears to be the most acute, but it is worth pointing out that this issue may become more widespread as populists surge into power across the developed world.

The yardstick for this first goal is usually the rate of inflation in the economy. Most central banks, including the Fed, target a 2% annual increase in the price level. The main policy tool they use for this is the manipulation of interest rates – effectively, the price of money. Lower interest rates mean that it is more advantageous for consumers to hold liquid money instead of bonds (which pay interest at the rate the Fed sets). This leads to expansionary

economic activity, increasing growth and reducing unemployment but potentially

putting upward pressure on prices.

Most central banks in the developed world are said to be “independent” because the

government has no influence over the policy they pursue. However, US President Donald Trump’s impending appointment of a new chair in early 2026 who is expected to be

politically aligned with the president himself has raised the question of whether

policymakers at the Fed will set a future interest rate path at the implicit direction of the

president. This would involve lowering interest rates faster, keeping unemployment

artificially low and providing a short-term boost to the economy. But at what cost?

The most important ramification of a loss of central-bank independence is a potential

loss of confidence in the Fed’s willingness to keep inflation at target. The short run

effect will be to boost growth temporarily, as lower interest rates benefit borrowers and

encourage people to spend, thereby increasing GDP. However, we will mostly focus on

long-term effects.

Here, there is a risk that artificially low interest rates lead to a loss of consumer and

investor confidence in the Fed to do its core job of maintaining price stability. This leads

to self-perpetuating inflation, which must eventually be addressed, thereby harming

growth more severely later on.

Let’s look at a few examples from the macroeconomy to illustrate these points.

Firstly, perception among consumers that the Fed will no longer stick to its 2% target

(regardless of whether that view is justified) can cause higher short-run inflation. After

all, if you think your money is going to be worth less in the future, why would you not

spend more of it now? This increased spending leads to more money chasing the same

volume of goods, and thus higher prices.

Furthermore, investors like it when inflation is low and stable – it means they can be

sure about the value of their investments in the future. Increased uncertainty arising

from the perception that the Fed will simply do the political bidding of future presidents

will reduce their desire to invest in US assets. Why does this matter? The U.S. runs a

significant trade deficit of around 3% of GDP with the rest of the world (as Mr Trump

likes to remind us about). This means that it needs foreign investors to essentially “buy”

US investments to make up the difference. If foreign investors refuse to do this to the

same extent for the reasons discussed above, the US economy becomes more

exposed. The dollar will have to depreciate (making US exports more price competitive)

to involuntarily reduce the trade deficit. However, this also reduces the buying power of

US consumers on the foreign market, thereby increasing what we call “imported”

inflation.

There is a third, tangential factor at play here. Many Western nations, but particularly

the US, are running historically large fiscal deficits – where government spending

exceeds revenue and it must take on more debt as a result. The One Big Beautiful Bill Act

passed earlier this year is likely to add over $3tn to the deficit in the next ten years. This

implicitly pressures central banks to keep interest rates low to prevent a debt crisis (as

here the government has become a borrower), but the result is that the Fed stops using

interest rates to pursue stable prices and low unemployment, with predictable

consequences for price stability (or lack thereof).

All the effects outlined above show that an initial refusal to rigidly focus on maintaining

price stability will put more and more upward pressure on inflation. This means that

eventually the Fed will have to raise interest rates, potentially quite sharply. This

would be for political reasons if nothing else – high inflation is unpopular with voters, as

Mr Trump himself was able to exploit during the 2024 election. But by then, the damage

might be done. Interest rate hikes will sharply slow growth, and the loss of confidence

in American monetary policy mean that baseline interest rates will be permanently

higher in the future.

We’ve considered a fair amount of theory here, but is this borne out by historical

experience? We can turn to the US itself for an instructive example from the past.

In 1972, Richard Nixon successfully pressured Fed chair Arthur Burns to keep interest

rates low in the year of his re-election, thereby keeping unemployment down and giving

the economy a short-term boost.. This certainly suited Nixon – he enjoyed a landslide re-election that year on the back of 6.5% annual growth. However, this contributed significantly to the inflationary crisis of the late 1970s and 1980s. The inflationary spike was addressed by the policies of the Reagan Administration, but not without a sharp recession that saw unemployment rise to almost 11%.

There is therefore compelling evidence that a loss of central bank independence,

through the channels described above, will inflict serious long-term harm to the

economy even if these effects take time to materialise. Ultimately, it is difficult to tell

how serious such consequences might be, or indeed if they will even be fully realised.

Inflation lingering above target for a few years is unlikely to do serious harm and may

even benefit short-run growth. But institutions like the Fed rely on consumers and

investors being confident in them to stick to their own targets regardless of the

prevailing political currents. If that confidence is lost, the U.S. economy is looking at a

very uncertain future indeed.

The views and opinions expressed in this article belong solely to the writer and do not necessarily reflect the views and opinions of the Warwick Economics Summit.

Reference list

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