Wage Indexation, Central Bank Independence and the Cost of Disinflation

Recently, Fischer [1996] and Posen [1998] demonstrated empirically that countries with less independent central banks enjoy lower output losses during disinflationary cycles. Since independence is presume to provide a credibility bonus to the monetary policy, this conclusion looks surprising. To explain their paradoxical result, these authors put forward that independent central banks probably face a flatter short-run Phillips curve. In this paper, we provide a formal demonstration of this point. More precisely, we demonstrate that the private sector has less incentive to index its nominal wages when the central bank is granted with a large amount of independence. Since an increased indexation steepens the short-run Phillips curve, our result is consistent with the view that where central bank independence is greater, the cost of disinflation is higher. Our empirical tests, for a sample of 19 OECD countries, support our theoretical analysis. In particular, a negative and significant relationship is found between indexation and independence.