Coursework

The bank of england independence

Though the post-1992 institutional changes placed some constraints on the ability of the Chancellor to base interest rate decisions on political rather than economic considerations, the discipline was inevitably only partially given the scope for differences in view about the prospects for inflation.

Thus a Chancellor could judge that interest rates should be lower than the Governor either because of genuine differences in view about economic prospects or because of political considerations. As an outside observer could never be sure that it was the former rather than the latter, the new arrangements lacked full credibility. That lack of full credibility is evident in long-term (10 year) inflation expectations implied from a comparison of the yields on nominal and indexed government debt.

A lack of counter-inflationary credibility in monetary policy was potentially even more of an issue for the incoming Labour government that took power on 1st May 1997. The economic record of the previous Labour government over the 1974-79 period had not proved a success and part of Labour’s objective while in opposition had been to show they could be trusted with the economy. To help substantiate that, Chancellor Gordon Brown’s first act was to hand over operational responsibility for achieving the inflation target to the Bank of England, or more precisely a Monetary Policy Committee (MPC) that comprised five bank officials and four external experts. But unlike some other central banks, responsibility for setting inflation targets remained the Chancellor’s. This act generated an immediate credibility gain as long-term inflation expectations fell by more than half a percentage point. That was followed by further gains over subsequent months as inflation expectations converged on the target of 2.5%.

Despite these credibility gains, it is worth noting that giving the Bank operational independence was nevertheless seen as a revolutionary step and did not immediately gain the wholehearted support of all sections of the parliamentary Labour party. This is important, as aspects of the UK model stem from the context in which it was forged. In particular, it would probably have been a step too far to also allow the Bank to set the target. It also explains the considerable stress placed on the accountability of the MPC.

The New regime required legislative changes and these are embodied in the Bank of England Act (1998). That charges the bank ‘to maintain price stability, and subject to that to support the economic policy of the government, including the objectives for growth and employment’. The lexicographic structure of this general objective imitates the wording in Article 105 of the Maastricht Treaty laying out the statutory objectives of the European Central Bank (ECB). But in contrast to the ECB which is free to choose exactly how it interprets its general objective, the MPC is each year provided with a remit by the Chancellor which defines ‘price stability’ more precisely. So as to maintain continuity with the pre-1997 regime, that was chosen to be an annual rate of inflation of 2.5% for RPIX ‘at all times’. The remit has remained the same since then, though the Chancellor announced in his June 2003statement on euro entry that the targeted measure would in due course be changed to Harmonised Index of Consumer Prices (HCIP), the corresponding measure to that used by the ECB. The remit also identifies the ‘economic policy of the government’, namely the maintenance of high and stable levels of growth and employment.

From time to time this framework has been criticised for paying insufficient attention to economic objectives other than inflation (though the critics usually believe that the statement of objectives makes no reference whatsoever to growth, employment, etc. It is also sometimes suggested that the statement of objectives should put equal weight on inflation and activity, as is the case in the United States with the Federal Reserve.

Are there grounds to think the objective is too focused on inflation? In the Chancellor’s original letter to the Governor at the time of independence makes clear that, although the target is 2.5% ‘at all times’, we are not expected to achieve it continuously. Inevitably from time to time, there will be demand and supply shocks that drive inflation away from the intended target. Given the lags inherent in the transmission mechanism of monetary policy, it may be difficult to offset such shocks if they are temporary and will have faded by the time the effect of any change in interest rates is starting to be felt. And even some shocks could be offset in principle; there may nevertheless be a good case for allowing temporary slippage relative to target in order to avoid undue volatility in activity; that is particularly the case with some sorts of supply shock. The Governor of the Bank of England stated that ‘in essence, we have a degree of ‘constrained discretion’ in deciding exactly how to deal with shocks and how quickly to plan to bring inflation back to target when it has moved away (King, 1997).

Of course, the remit does not specify the relative weight we are supposed to place on deviations of inflation from target and output potential. So the ‘contract’ between the government and the Bank is incomplete. Svensson (2003) argues that in the interests of transparency the members of the MPC ought to reveal their individual or collective objective function, and in particular the relative weight placed on deviations of inflation from target and output from potential. Empirical evidence suggests that the ‘Taylor Frontier’ that traces out the minimum feasible inflation variance for a given output variance may be quite sharply curved. In that case a wide range of plausible loss of functions lead to a rather similar policy choice (Bean, 1998). More importantly, any deviation of inflation of more than 1% either side of the target triggers an open letter from the Governor to the Chancellor, which amongst other things is supposed to say how quickly the MPC expect to bring inflation back to target. The Chancellors (Open) response to that letter would allow him to indicate whether that was too rapid, or not rapid enough, if he so wished.

Another valuable of feature of the UK model that is worth highlighting here is the emphasis placed on accountability that is accompanied by the decision to delegate operational responsibility for monetary policy to the MPC. The primary channels are threefold. Firstly, the MPC is accountable to the ‘Court of the Bank’ whose job is to oversee the committee’s processes though not its interest rate decisions. Second, members of the MPC appear before the appropriate Committee of parliament, usually shortly after the publication of the Inflation Report, to be questioned about the reasoning behind interest rate decisions. Importantly, members are held individually accountable for their votes. Thirdly, as already stated, if inflation deviates more than one percentage point from target, the Governor is expected to write an open letter to the Chancellor explaining why the deviation has occurred, what action the committee is taking to bring inflation back to target, and how that is consistent with the government’s general economic policies.

With regard to performance, Macroeconomic performance since the inception of inflation targeting in October 1992, has probably exceeded the expectations of most observers. RPIX inflation has averaged 2.6%, and GDP growth has averaged 2.8%; since Bank independence the corresponding figures are 2.4% and 2.5%. Given previous experience, both growth and inflation have also been remarkably stable.

Should any significance be attached to the slight tendency for inflation for undershoot the target independence? First, it should be said that this was not the result of conscious decision by the committee because, as already noted, the published forecasts usually showed the central projection close to target by the end of the forecast horizon.