The Bank of England was granted independence to set interest rates back in 1997. This is known as instrument independence. However, the remit is set by the government and so it does not have goal independence. Amongst the policy announcements on Budget day (Wed 20 March), the government detailed amendments to the Bank’s remit. In particular, the remit now more explicitly acknowledges that, in exceptional circumstances, the Bank might need to pay more attention to output variability.
Despite the amendments to its remit, the Bank of England continues to have a forward-looking operational inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point). The MPC therefore sets the Bank Rate, i.e. the rate at which it engages in short-term lending to financial institutions, to affect general interest rates in the economy. In turn, the level of interest rates is assumed to affect the level of aggregate demand and, hence, the rate of demand-pull inflation as well as inflation rate expectations.
A key economic benefit of delegating interest rate decisions to the Monetary Policy Committee (MPC) is thought to be lower inflation rate expectations. By granting the Bank of England operational or instrument independence, inflation announcements have a credibility that they would not if monetary policy was under the control of elected politicians. So why change the inflation rate remit?
The government remains of the view that inflation rate targeting has served the UK well, despite inflation being persistently above target for the past three years (see chart: click here for a PowerPoint). However, it has sought to clarify how the Bank of England might be expected to behave in exceptional circumstances when the economy is buffeted by shocks and disturbances, such as those that it has faced following the financial crisis of the late 2000s. The government argues that in such circumstances the output volatility that could result by ensuring that inflation remains on target could be undesirable. Therefore, the MPC should give consideration to the volatility of output that targeting inflation would cause in such exceptional circumstances.
The amended remit says that in setting monetary policy the MPC should communicate to the public the trade-offs that are inherent in meeting its forward-looking inflation rate target. Therefore, during exceptional times, the Bank may communicate that the volatility of output resulting from returning inflation to target would be so large that it is prepared to keep monetary policy looser than it otherwise would. This could mean indicating a time-frame over which it would be expected to keep interest rates lower than otherwise. By communicating this, it would in effect be looking to affect peoples’ expectations and, importantly, their behaviour. The prospect of prolonged low interest rates, such as those currently being experienced, might encourage greater expenditure, especially as a result of lower borrowing costs – though of course this is not guaranteed!
The Governor will continue to write an open letter to the Chancellor of the Exchequer if inflation moves away from the target by more than 1 percentage point in either direction. However, in a change to the previous remit, this will be done in conjunction with the minutes of the MPC meeting that follow the publication of the official inflation figures by the Office for National Statistics. By publishing the letter alongside the minutes, it gives the MPC more time to consider its strategy and to give due consideration to the trade-offs in returning inflation to the target. If inflation remains more than 1 percentage point above or below the target the Governor will need to write a further letter after three months. This letter would be alongside the minutes of the third subsequent meeting of the MPC.
Some commentators argue that the amended remit is merely a reflection of the current reality. In other words, the remit is being rewritten in a way which reflects how the MPC is currently making its interest rate decisions. Others are concerned that what was a simple and clear objective is now not the case and that this may have implications for the credibility of monetary policy. Whatever the rights and wrongs, Wednesday’s announcement was an important development in the history of central bank independence in the UK.
Remit for the Monetary Policy Committee Bank of England, March 2013
Governor Response to the remit for the Monetary Policy Committee Bank of England , March 2013
Bank of England handed new remit in Osbourne’s budget Guardian, Josephine Moulds (20/3/13)
Budget: Changing the Bank of England Remit Sky News, Ed Conway (20/3/13)
Budget 2013: Bank of England’s monetary policy remit changed Telegraph, Angela Monaghan (20/3/13)
King warns against ‘major change’ to Bank’s remit ITV News (15/3/13)
Chancellor adjusts Bank of England inflation remit Financial Times, Nick Reeve (20/3/13)
Budget 2013: Bank of England gets new orders BBC News (20/3/13)