22 CENTRAL BANKS AND HOW THEY STEER THE ECONOMY

What exactly is a central bank for? It is tempting to answer in a single word, inflation, and much of the time that is how the job is described. But this is one of the liveliest debates in economics, and there is no settled agreement. Should a central bank care only about holding prices steady? Or should it also watch over the exchange rate, keep the financial system safe, and pay attention to jobs and growth? Different schools of thought, which we come to later in this chapter, answer very differently, and we should be honest about that from the start rather than pretend the question is closed.

What almost everyone does agree on is narrower, but important. A central bank has a real and distinctive role to play, and it should play it independently. Its task is to arrange a country’s monetary policy at arm’s length from day-to-day politics. Institutions like the Bank of England or the Federal Reserve in the United States manage that policy to help keep the economy stable, and they are usually designed to work free of direct government control, so that short-term political pressure does not override long-term judgement. What that policy should ultimately aim at is exactly what is contested. That the central bank should be trusted to set it, independently and competently, is the part that commands wide support.

That independence is a cornerstone of modern economic governance. It is meant to ensure that monetary policy follows economic evidence and long-term stability rather than the needs of the next election. When a government controls monetary policy directly, it may be tempted to boost the economy just before an election, which can lead to unstable and unsustainable policy. An independent central bank can instead base its decisions on economic conditions and evidence.

Independence also lets a central bank act quickly in a crisis. During financial turmoil, a recession, or an external shock, policymakers cannot afford long political negotiations. An independent central bank can move on its own, whether by adjusting interest rates, providing liquidity, or stepping into financial markets. Acting decisively builds confidence, steadies markets, and stops trouble from spreading.

When a central bank is not independent, policy tends to serve short-term political interests instead of long-term stability. This is clearest in authoritarian states and in weak democracies, where governments often bend monetary policy to their own ends.

In such places, central banks are often pushed to fund government deficits by creating money, which leads to high inflation or even hyperinflation. Zimbabwe in the early 2000s and Venezuela in recent years show how a politically controlled central bank, forced to print money for unsustainable spending, can end in disaster. The currency collapses, inflation runs wild, and the economy falls apart.

Even in fragile democracies, where institutions are weak and decisions are not transparent, central banks face interference. Governments may press for artificially low interest rates to boost growth in the short term, whatever the later cost. Turkey is a recent example, where political pressure on the central bank produced policies that shook investor confidence and helped drive a steep fall in the currency. When politicians override the central bank’s expertise for their own needs, economic credibility erodes, capital flees, and inflation becomes unpredictable.

Where democratic institutions are weak, central banks can also become tools of patronage, serving a ruling elite rather than the public. Without safeguards, secrecy in decision-making opens the door to corruption, mismanagement, and policies that benefit a few at everyone else’s expense.

Independence, though, does not mean acting with no oversight. Transparency and accountability are essential, so that a central bank serves the economy rather than becoming a law unto itself. In healthy democracies, central banks are expected to explain their policies clearly, justify their decisions, and answer to parliament or other institutions, all without direct political meddling.

The way central bank leaders are appointed reflects this balance. The process differs by country, but the principle is the same. Leaders should be chosen for their expertise, experience, and ability to make independent decisions, not for political loyalty.

In the United States, the President nominates the Chair of the Federal Reserve, and the Senate must confirm the choice. This gives both the executive and the legislature a say. The Chair serves a four-year term that can be renewed, but, crucially, the President cannot simply remove them. That protects the central bank’s independence.

Alan Greenspan is a striking example of this long independence. He served as Fed Chair from 1987 to 2006, under four different presidents, Reagan, George H. W. Bush, Clinton, and George W. Bush. His nineteen years in the role show how a central banker can outlast many administrations, which reinforces the idea that monetary policy should sit apart from the election cycle. Today Jerome Powell chairs the Federal Reserve, first appointed in 2018 and reappointed for a second term due to end in 2026.

In the United Kingdom, the Governor of the Bank of England is appointed by the government, through the Chancellor of the Exchequer, and serves a fixed term of eight years, up from five before recent reforms. As in the United States, the Governor cannot be removed at will, which protects the Bank’s autonomy. Andrew Bailey has been Governor since 2020, with his term running to 2028.

A notable moment in British central banking was the appointment of Mark Carney, Governor from 2013 to 2020. Unlike his predecessors, Carney was not British. He was Canadian, and had been Governor of the Bank of Canada. Choosing him showed that the UK valued experience and expertise over nationality. After leaving the Bank of England, Carney entered Canadian politics and has since been seen as a possible future prime minister of Canada.

The European Central Bank, which runs monetary policy for the eurozone, uses a different process. Its President is appointed by the leaders of the eurozone countries for a single, non-renewable term of eight years. This keeps the ECB independent of any one national government and makes it a genuinely supranational institution. Because the term cannot be renewed, presidents have no reason to shape policy in the hope of reappointment.

Notable ECB presidents include Jean-Claude Trichet, from 2003 to 2011, who steered the bank through the early stages of the eurozone crisis; Mario Draghi, from 2011 to 2019, who famously promised to do whatever it takes to save the euro during the European debt crisis; and Christine Lagarde, from 2019, the first woman to lead the ECB, who had previously been Managing Director of the International Monetary Fund.

One of the most important features of central bank leadership is how long these leaders stay in post, compared with the short terms of elected politicians. A president or prime minister may serve four or five years. Central bank governors often serve eight to ten years or more. That lets them pursue long-term policies without political interference, and it is a key reason why financial markets and businesses trust them. If policy shifted with every election, uncertainty would rise and long-term investment would become riskier. Instead, the careful appointment processes in democracies let central bankers make hard decisions, such as raising interest rates to fight inflation, without fear of political revenge.

Central banks differ in who owns them. Most, like the European Central Bank and the Bank of Japan, are fully state-owned. There are exceptions. The Swiss National Bank is partly owned by private shareholders, with some shares traded on the stock market, and the Federal Reserve has an unusual structure in which its regional banks are partly owned by private member banks. The Bank of England has been wholly owned by the UK government since it was nationalised in 1946, yet it still sets monetary policy independently.

Central banks are not only bodies that set interest rates. They are among the most research-driven organisations in the world. The Federal Reserve, the Bank of England, and the European Central Bank employ thousands of highly skilled people, including many economists with doctorates from leading universities. These experts spend their careers analysing economic data, carrying out research, and shaping policy through careful method rather than guesswork.

The scale is worth grasping. The Federal Reserve employs around 23,000 people across its head office in Washington and its twelve regional banks, including hundreds of PhD economists from universities such as Harvard, MIT, and Princeton. The Bank of England has around 4,000 staff, with a dedicated team working on monetary policy and financial stability. The European Central Bank, overseeing the whole eurozone, has around 3,500 staff, including a large research department.

These institutions do not rely on a few broad indicators. They study millions of data points. Every price movement, employment figure, measure of output, and financial transaction is examined to judge the health of the economy. They use advanced models, artificial intelligence, and historical analysis to forecast trends and guide policy. They are also deeply involved in academic research, publishing papers, holding conferences, and working with leading economists, so that decisions rest on the latest evidence.

For all the data and modelling, central banking still needs real-world insight. This is where the personal inquiries of central bank leaders come in. Alongside the statistics, they want ground-level information that the numbers may miss, so they call businesses, supply chain managers, and industry leaders to hear how things really are. In times of uncertainty, the Chair of the Federal Reserve might call the ports of Los Angeles and Long Beach, among the largest shipping hubs in the country, to ask about freight traffic, bottlenecks, and demand. Containers piling up or ships being delayed can signal a slowing of global trade. In the UK, the Governor of the Bank of England might contact executives at the Port of Felixstowe or at major manufacturers to ask about order volumes and investment plans. The President of the ECB might call the ports of Rotterdam, Antwerp, or Barcelona to check the flow of shipments, a key sign of European trade and industry. Central bankers also speak directly to the chief executives of big firms, from carmakers to retailers to tech companies, to learn how they are coping with changes in demand, supply, or labour. If manufacturers report falling orders, it can point to a coming slowdown and prompt a change in policy.

When it comes to the aims of monetary policy, there is a long-running debate, with different schools offering different answers. The classical or monetarist school argues that there is a direct link between the money supply and inflation, again the idea of too much money chasing too few goods. On this view the central bank ultimately controls the money supply, so inflation can be managed by controlling how fast money grows. Following Milton Friedman, monetarists favour a fixed, steady growth rate for the money supply to keep prices stable. In the 1980s the Federal Reserve under Paul Volcker leaned on this approach, restraining money growth to break high inflation. It worked in that case, but the link between money and inflation can be unpredictable, because the speed at which money circulates changes and financial innovation keeps shifting the picture.

The second approach is inflation targeting, linked to the New Keynesian school, and it is the one most central banks use today. The idea is simple to state. Pick a target, usually around 2 per cent, and move the interest rate to keep inflation close to it. If inflation climbs above target, raise rates to cool spending. If it drifts below, cut rates to warm the economy up. Think of it as a thermostat for a whole country. When things run too hot, the central bank turns the dial one way. When they run cold, it turns it back.

But a good thermostat reads more than one thing, and this is where the Taylor Rule comes in. Named after the economist John Taylor, it is really a rule of thumb for where to set the interest rate, and it watches two things at once. The first is how far inflation is running above or below the 2 per cent target. The second is the output gap, a slightly technical term for a simple idea: how far the economy is running above or below its normal, healthy level, the pace at which people and factories are busy but not overstretched. If prices are rising fast and the economy is racing along, the rule says the economy is overheating, so raise rates firmly. If inflation is high but the economy is actually weak, the rule says tread carefully. The point of such a rule is not that anyone follows it to the last decimal. It is that it makes the central bank predictable. Households and businesses can sense roughly what it will do next, and that alone is calming. The Bank of England has worked in this broad way since it adopted an inflation target in 1992, and most central banks have followed since.

The interest rate is the main dial, but it is not the only one. A modern central bank also steers by talking. When it signals clearly what it intends to do with rates in the months ahead, it shapes the choices people make today, because a family taking out a mortgage or a firm weighing a new factory cares as much about where rates are heading as where they sit right now. This is called forward guidance, and words, chosen carefully, can move an economy almost as much as actions can. It also helps to see how a single decision travels. When the central bank nudges its rate up, banks charge more for mortgages and business loans, so families have a little less to spend and firms hold back on investment. Demand cools, and after a while prices ease. The chain takes months to work through, which is part of what makes the job so hard. The central bank is always aiming at where the economy will be, not where it is. And when rates have already been cut as far as they can go and still are not enough, central banks reach for heavier tools, such as creating new money to buy financial assets, a policy known as quantitative easing. That tool, and the trouble it can cause, is the story of the next chapter.

The post-Keynesian school offers a broader critique of both. It accepts that inflation targeting can be one aim, but argues that it should not be the only one. In this view, central banks are above all the ultimate supplier of liquidity, and by setting the price of that liquidity, the interest rate, they shape the cost of borrowing and production across the economy. When they raise rates, borrowing becomes dearer, and since firms borrow to produce and invest, their costs rise and can be passed on as higher prices. So interest rate policy can itself feed cost-push inflation. Post-Keynesians also stress that money is created within the banking system in response to the demand for credit, rather than controlled from the top by the central bank.

For these reasons, post-Keynesians warn against making inflation the sole focus. An aggressive drive to hold inflation down can choke growth, raise unemployment, and widen inequality. They argue that central banks should hold wider goals. One is financial stability, since a stable financial system underpins lasting growth. The global financial crisis of 2008 showed the danger of watching inflation while ignoring risks building up in the financial sector. Another priority, especially for open economies, is managing the exchange rate. Where goods and capital flow freely across borders, a sharp fall in the currency can import inflation by raising the price of foreign goods. Countries such as India or Brazil, where exchange rate swings feed into domestic prices, can benefit from steadier currencies. The Asian financial crisis of the late 1990s, which hit countries with pegged exchange rates hard, showed why careful exchange rate management matters, particularly in emerging economies.

The wider post-Keynesian message is a call for a more flexible, joined-up approach. Inflation, financial stability, and exchange rates are all connected, especially in a globalised world. A central bank that fixes only on a narrow inflation target risks neglecting the rest and destabilising the economy over the longer run. The European Central Bank’s strict inflation target, for instance, has at times sat awkwardly with its role in steadying the financial system during eurozone crises. The aim, on this view, should be to weigh these competing priorities together, so that central banks support lasting development rather than price stability alone.