Central bank financial strength and inflation: Is there a robust link?

• Published in: Journal of financial stability 2013-09, Vol.9 (3), p.399-414
• Main Authors: Perera, Anil, Ralston, Deborah, Wickramanayake, Jayasinghe
• Format: Article
• Language: English
• Subjects: Central bank capital; Central bank financial strength; GMM method; Inflation; Panel estimates
• ISSN: 1572-3089; 1878-0962
• DOI: 10.1016/j.jfs.2013.06.005

•We examine the relationship between central bank financial strength and inflation.•We observe that inflation is negatively associated with central bank financial strength.•This relationship is robust for deeper determinants of inflation and for alternative estimation methods.•Central bank balance sheet health is a vital for achieving desirable policy outcomes. 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.