Central bank independence and time inconsistency

Time inconsistency describes a situation where a policy that is optimal today ceases to be so tomorrow, tempting the decision-maker to go back on their word. Applied to money: a government promises low inflation to anchor expectations; but once wages and contracts are set on that promise, it is tempted to create a surprise inflation to boost employment, exploiting the Phillips curve. Agents, aware of this temptation, anticipate it and demand more up front. The result: higher inflation, with no gain in activity at all. This is the "inflation bias" of discretionary decision-making, formalized by Finn Kydland and Edward Prescott (Nobel Prize 2004) and then by Robert Barro and David Gordon.

Since the discretionary promise is not credible, the solution is to take money out of the hands of power and entrust it to an independent central bank, endowed with both goal independence (the target, often 2% inflation) and instrument independence (setting rates). The classic image is the mast of Ulysses: society binds itself so as not to succumb to the song of easy money. Independence does not remove the temptation; it places between temptation and action a guardian who has no reason to yield to it. The credibility the collective cannot produce on its own, it borrows from the institution.

Kenneth Rogoff refined the remedy: to neutralize the inflation bias, entrust money to a central banker more inflation-averse than society on average. A guardian who, by temperament and by mandate, structurally prefers price stability reassures markets and anchors expectations. But the coin has a flip side: a banker too conservative, obsessed with inflation to the point of neglecting jobs and growth, also has a cost. Independence is therefore not an end in itself; it is a balance between anti-inflation credibility and regard for activity, under the gaze of democratic legitimacy.

The rates that matter for the economy, those on long-term borrowing, form in the market: they price in expected inflation and a risk premium. If lenders doubt the guardian's resolve, they demand a wider premium and rates rise on their own. Conversely, a credible central bank compresses that premium and keeps rates low. Credibility is earned by refusing to yield, even to the one who appointed the governor: it is that refusal which anchors expectations. Where independence yields to the pressure of power, the opposite is seen: a weakened currency and inflation, as the episodes of dismissing recalcitrant governors illustrate.