Central Bank Independence at Low Interest Rates

We create a new measure of the political pressure faced by the Federal Reserve based on the analysis of transcripts of the Chairs’ testimonies to Congress. We find that the use of non-traditional policies at low interest rates led to increased political criticism and that criticism predicts legislative actions that threaten central bank independence. We develop a model where the probability of the monetary authority’s future loss of independence is increasing in the use of non-traditional instruments, leading to attenuated monetary responses and higher inflation volatility. We show that this attenuation can be mitigated under an institutional framework with clearly defined targets where the central bank is evaluated by how efficiently it achieves its goals.