Why is central bank independence important and what happens when it is under attack?

Donald Trump is overcome by his anxiety to seize control of the Federal Reserve, the most powerful central bank in the world, the one that sets the price of money in the United States and thereby sets the benchmark for the cost of a mortgage or paying interest on public debt. As he announced on his social media platform, the U.S. president has moved to fire Governor Lisa Cook on charges of mortgage fraud, a dismissal she claims has no legal basis. The political assault has finally erupted at the Fed in a case that promises to end up in court and further tightens the noose around the institution’s chairman, Jerome Powell, whose term ends in May 2026.

Cook’s dismissal is in fact yet another step, the most significant so far, in Trump’s brazen aspiration to control the Fed’s decisions, over when to push the rate cut button. And this unprecedented pressure from the White House torpedoes what in recent decades seemed a principle set in stone for central banks in developed economies: their independence from political power. Economists and bankers warn about the risks of questioning that independence, of the damage it poses to investor confidence in a country’s economy, and the harm it can ultimately cause to citizens’ wallets. Economic theory warns against the aspirations of heads of government to interfere in the work of central bankers, but why is it better that way?

Why is central bank independence important?

Central banks are not strictly independent; their governors are, in fact, appointed by the political establishment, although they are also institutions protected by laws that recognize the autonomy and independence of their management. This independence in decision-making has emerged in recent decades from a sort of separation of powers dictated by experience and the evidence that central banks that are not influenced by political pressure are more effective in fulfilling their mandate. That mandate is price stability, that is, controlling inflation, although in the case of the Fed, its objective is also full employment. In short, acting to prevent runaway prices and skyrocketing unemployment. And political interference can derail them from effectively fulfilling those objectives.

“Governments face multiple temptations: pushing to lower interest rates before elections in an attempt to artificially stimulate the economy, even if this generates future inflation; and, in more extreme cases, using the central bank to directly finance public spending through massive purchases of government debt or monetary issuance, which has historically led to devastating hyperinflationary processes,” explains Judith Arnal, senior researcher for Economic Affairs at the Elcano Royal Institute and a board member of the Bank of Spain.

Roughly speaking, central banks are the money factory: lowering interest rates allows for cheaper borrowing and more spending, thus boosting the economy. They also allow governments to increase public spending, thereby increasing their debt levels, a clearly tempting practice right before elections. But these rate cuts can also weigh heavily on the future, and central banks must be on the lookout to avoid undesirable effects.

Low or very low interest rates are also the seeds of financial and real estate bubbles, or in the worst-case scenario, the beginning of sovereign debt crises or inflationary spirals that can get out of control. And with rising inflation, even more so if it’s out of control, the answer lies in interest rate hikes, a cold shower with which to try to stem the overheating of the economy, but which is highly unpopular due to its other effects, such as higher mortgage prices, higher business costs, or even job losses. As a recent example, the price increases that began with the economic collapse following the Covid pandemic and deepened in Europe with the war in Ukraine, forced a wave of interest rate hikes, which, as many central bankers acknowledged, was painful, but which ultimately managed to contain inflation.

​​​​​​​​​​​​​​​​What harmful effects can a central bank acting under pressure from political power have on the economy and on citizens’ wallets?

Bubbles don’t emerge out of nowhere, and the collapse of the real estate and banking boom that devastated the Spanish economy in 2012 still weighs heavily. Central banks must also ensure financial stability, acting as an impartial supervisor of the banking system and issuing warnings when credit is becoming excessive. If political power encourages loans without criticism or oversight from the central bank, it’s easy for this boom to end like the milkmaid’s tale. With costly public bailouts at taxpayer expense, business bankruptcies, and the loss of savings and jobs.

The euro crisis erupted after years of banking malpractice and fiscal imbalances, although it had a valuable ally in its resolution. When investors decided it was too risky to invest in Spain or Italy, thereby calling into question the entire European project, the then-president of the European Central Bank, Mario Draghi, demonstrated the institution’s unwavering commitment to saving the single currency by doing “whatever it takes.” And the market believed him. “Draghi had sufficient credibility, and that was decisive. We’ll see how much credibility Powell’s successor inspires,” notes Santiago Carbó, a professor of economics at the University of Valencia and researcher at Funcas. As Arnal points out, “the central bank’s loss of credibility generates uncertainty in the markets, increases country risk premiums, and distorts long-term investment and savings decisions, creating a vicious cycle of economic instability.”

What lessons does the recent history of central banks that lost their independence offer?

The United States is the world’s largest economy and military power and enjoys the most powerful currency, the dollar, the undisputed benchmark for trade and financial transactions. But U.S. policies are weakening its reign: Trump has introduced a tax reform that will increase the deficit and debt levels, for which he needs lower interest rates. The U.S. president seems willing to push the envelope to the limit, with investors anticipating a weaker dollar but not the end of its financial hegemony. “Trump is playing with fire; he could undermine the Fed’s credibility in the medium term,” warns Salvador Jiménez, an analyst at AFI. The U.S. has a debt level exceeding 120% of GDP, amounting to more than $36 trillion, and a public deficit of around 7% of GDP. And to finance itself, it needs investors to buy huge amounts of sovereign debt.

The United States is far from being an emerging economy, but what happened in recent decades in Turkey and Argentina provides clear examples of the effects of a central bank’s loss of independence. In Turkey, President Recep Tayyip Erdogan’s pressure to keep interest rates low at all costs in order to boost growth and exports resulted in a crisis for his currency, with the Turkish lira at rock bottom and inflation exceeding 80%. However, since 2023, Erdogan has returned to economic orthodoxy and has shown greater respect for the central bank’s independence, which has begun to stabilize the situation.

Argentina represents, according to Judith Arnal, “an extreme case of deficit monetization: decades of political pressure on the central bank to finance public spending have generated recurrent inflationary crises and a total loss of confidence in the national currency. The result has been a de facto dollarization of the economy and massive impoverishment.” And Zimbabwe represents the most extreme case: the complete subordination of the central bank to political power led to hyperinflation that reached 89.7 sextillion percent annually, completely destroying the economy and forcing the country to abandon its own currency. As Arnal concludes, “these experiences demonstrate that the loss of independence can be devastating for both price stability and the soundness of the financial system.”

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