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Central bank financial strength has not been a fundamental issue for a substantial period of time. However, recent theoretical and empirical studies argue that central banks need to maintain a sufficient level of financial strength to perform their functions effectively and to achieve monetary policy objectives. In this study, we examine the empirical relationship between central bank financial strength and inflation using an unbalanced panel data set for a sample of selected advanced and emerging countries. We observe a statistically significant and robust negative relationship between central bank financial strength and inflation. This relationship is robust in the presence of other determinants of inflation and for alternative estimation methods. Our results have important implications for policy makers and central bankers. Particularly, our results suggest that avoiding persistent losses and maintaining the health of the central bank balance sheet remain vital pre-conditions for desirable policy outcomes of a central bank.

In this study, we focus on a long-neglected aspect of central banking, i.e. central bank financial strength (CBFS, hereafter) and its relevance to achieve low inflation, which is one of the main considerations of modern central banking.1 Why the study of CBFS and its implications is important? During the past few decades, central banking has experienced significant changes (Sweidan, 2011). On the one hand, while their independence has been enhanced substantially, central banks have become more powerful amongst the policy making authorities. Moreover, the role of central banks is further changing due to the current focus on additional macro-prudential policies, particularly with regard to financial stability objectives (Goodhart, 2011). On the other hand, during the last few decades, many central banks have had experienced financial difficulties due to substantial operating and valuation losses. In particular, emerging country central banks have reported substantial deteriorations in their balance sheets.2 These financial difficulties raise important issues with regard to central bank monetary policy conduct and the effectiveness of policy outcomes. In particular, studies show that although marginal changes or transient movements in central bank financial conditions are immaterial, severe financial problems tend to degrade the policy capacity and limit the policy options available to a central bank. More importantly, weak financial conditions affect central bank policy outcomes (Cukierman, 2008, Stella, 1997 and Stella, 2008).3 Nevertheless, for a long period of time, central bank finances have not been a fundamental issue.4 This is because, financial strength of a central bank was considered irrelevant and insignificant due to several reasons and hence, it was largely neglected.5 However, such negligence has led to several negative economic consequences and affected the effectiveness of central banking and monetary policy (Sweidan, 2011). Hence, central bank financial conditions have received much more attention in recent academic literature and central bank practice. Even with current developments in central banking, for example, extensive interventions to mitigate the impact of the crisis, central bank balance sheet health is considered vital and desirable (Dalla Pellegrina et al., 2013). However, although CBFS and its relation to policy outcomes have recently been recognised as an important policy issue, this area remains largely under-researched. On the one hand, as argued by Jeanne and Svensson (2007), while central bankers do seem to care about central bank finances, such concerns however have not been much examined in the academic literature. On the other hand, although some case study evidence, for example, Ize (2007) and Stella, 2005 and Stella, 2008 indicate that weak central bank finances adversely affect the effective policy implementation, the relationship between CBFS and policy outcomes is not clear and is subject to controversy. This is partly due to paucity of robust econometric evidence (Klüh and Stella, 2008). In this background, the existing lacuna in research into CBFS and policy outcomes mainly motivates our study. We contribute to the limited existing literature in this area mainly in three ways. First, as advocated in similar research, which focuses on the determinants of inflation, for example, Aisen and Veiga (2006), we investigate the relationship between CBFS and inflation controlling for deeper determinants of inflation. Second, in contrast to the existing literature of CBFS, for example, Klüh and Stella (2008), we search for a link between CBFS and inflation using robust estimation methods. Third, unlike the existing literature, we account for heterogeneity between advanced and emerging countries and also consider the degree of central bank independence while focusing on different monetary and exchange rate regimes by performing sub-sample analyses. This is particularly important as financial conditions of emerging country central banks have shown more vulnerability (Sweidan and Maghyereh, 2006). It is also due to the fact that central bank financial conditions and its independence are largely associated (Cukierman, 2008). Moreover, it is evident that CBFS is largely influenced by applied monetary policy and the exchange rate regime of a particular country.6 Our empirical results reveal a robust negative relationship between CBFS and inflation. This connection between CBFS and inflation is not due to biases created by endogeneity or unobserved country-specific effects as we use more robust estimation methods. Our results and the policy inferences of our study would be useful for relevant authorities, and specifically for policy makers in emerging countries in the process of better calibrating monetary policy conduct in pursuit of achieving the key mandate of price stability. In particular, our study mainly suggests that policy makers should be aware that it is essential to maintain the financial health of the central bank balance sheet conducive to long run price stability. To that end, our results imply that measures aimed at reducing persistent central bank losses and increasing the financial strength of the central bank would help to reduce inflation. The remainder of the paper is structured as follows: In the next section, we provide a conceptual overview of CBFS and review relevant theoretical underpinnings and empirical evidence. In Section 3, we discuss the methodology and data. In Section 4, we present the empirical analysis and the results. Finally, in Section 5, we conclude the study with a brief discussion on policy implications and the directions for future research.

The predominant view is that central banks do not require any financial strength or given the structure of their balance sheet, central banks should always be profitable entities without financial difficulties. However, the academic literature strongly argues that even a central bank could experience financial difficulties and such weak financial conditions could have negative ramifications on the sustainability and effectiveness of central bank functions as well as on the outcomes of central bank policy. To that end, our study attempts to provide empirical evidence towards establishing a robust relationship between CBFS and the central bank's key policy outcome variable, inflation. In this study, mainly using the dynamic panel data system GMM estimator on a sample of selected advanced and emerging countries, we find that greater CBFS tends to generate low inflation rates. Hence, we broadly conclude that financial strength of a central bank is vital to maintain price stability, which is one of the primary considerations of a modern central bank and hence to achieve its overriding objectives. Our findings and observations provide important policy implications for policy makers. In particular, the robust relationship between CBFS and inflation suggests that central banks would need to avoid losses with a view to maintain their balance sheet strength and hence to support low inflation outcomes. Otherwise, inflation stabilisation efforts could be only temporarily effective and the long-term price stability may not be achieved if central banks do not consider the impact of their weak financial conditions. The sub-sample analysis suggests that CBFS is important to lower inflation particularly in the context of emerging countries. Individual country examples reported in the prior literature too, confirms that emerging countries are more prone to weaker CBFS given their institutional arrangements and central bank practices and resulting higher inflation rates. This suggests that emerging countries would need to emphasise the importance of maintaining their CBFS on a sustainable basis in order to support persistently low inflation episodes. Moreover, the sub-samples, which have been classified based on the level of central bank independence and applied monetary and exchange rate regimes, further suggest the importance of CBFS to support low inflation. For example, the results suggest that CBFS is important to lower the inflation rates when the central bank independence is low. To that end, the importance of higher CBI as well as the greater CBFS is much pronounced. At the same time, as there is a strong relationship between CBFS and inflation in non-inflation targeting countries, the relevance of CBFS for low inflation outcomes assumes vital importance for countries that adopt monetary policy regimes other than inflation targeting frameworks. To that end, our results suggest that monetary policy in countries without any inflation target needs to be supported by greater CBFS in order to generate low inflation rates. Moreover, CBFS appears much relevant for countries adopting fixed exchange rate regimes. In addition, our results also imply that the level of economic development and higher levels of central bank independence remain important determinants of inflation. The conclusions of this study however rely on a selected group of countries and hence, its results may not be generalised in the context of different economic and financial conditions. At the same time, it remains a pre-condition to establish a sound theoretical and methodological guide to develop representative measures and proxies of CBFS and hence to construct a reliable database for different measures. Further, alternative methodological specifications and additional controls for other exogenous shocks would be required while expanding the sample size in order to observe more robust relationships between CBFS and inflation outcomes. Also, since the theoretical propositions with regard to CBFS and the policy outcomes are subject to debate, there remains a vital requirement to strengthen the theoretical framework of CBFS, particularly focusing on the impact on other macroeconomic outcomes, for example, output gap or growth volatility. Hence, the need for conducting further theoretical and empirical research on the foundations of central bank financial strength and their implications is much more pronounced.