Central Bank Independence and Macro-Prudential Regulation

IMF Working Papers, April 1, 2012

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Paper examines optimal institutional arrangements for agencies conducting macro-prudential regulation and monetary policy.
Main mechanism identified: when a central bank is responsible for both price and financial stability, a new time inconsistency problem can arise.
Ex-ante, the central bank chooses the socially optimal level of inflation. Ex-post, the central bank may choose inflation above the social optimum to reduce the real value of private debt.
This inefficient outcome occurs when macro-prudential policies cannot be adjusted as frequently as monetary policy.
The time inconsistency result holds even when the central bank is politically independent.
The paper extends the analysis to include political pressures in the spirit of Barro and Gordon (1983): if either the macro-prudential regulator or the central bank (or both) are not politically independent, separation of price and financial stability objectives does not deliver the social optimum.

A central bank charged with both price and financial stability faces an ex-ante/ex-post conflict that can lead to inflation above the social optimum to inflate away private debt.
Asymmetric adjustment frequency between macro-prudential tools and monetary policy (macro-prudential tools less adjustable) is a crucial condition for the identified inefficiency.
Political independence of the central bank alone does not prevent the inefficiency if the institutional design places both objectives in the central bank’s mandate.
Lack of political independence in either the macro-prudential regulator or the central bank undermines the effectiveness of separating price and financial stability objectives.

Institutional design should account for the potential time inconsistency when assigning both price and financial stability mandates to a single central bank.
Consideration needed for the relative adjustability (frequency and flexibility) of macro-prudential tools versus monetary policy instruments.
Political independence of institutions matters, but independence of just one institution (central bank or macro-prudential regulator) may be insufficient to guarantee socially optimal outcomes.
Separation of objectives (price versus financial stability) is not guaranteed to produce the social optimum unless institutional arrangements address both time inconsistency risks and political pressures.