Questions of credibility

The Bank of England was granted independence to set interest rates back in 1997. In setting rates its looks to meet the government’s annual inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point).

The economic benefits of delegating interest rate decisions to a body like the Monetary Policy Committee (MPC) are often taken for granted. But, in David Blanchflower’s article in the Independent Newspaper on 14 May, the former MPC member questions whether, at least in recent years, better decisions would have been made by the Treasury and the Chancellor of the Exchequer. In other words, could politicians have made more appropriate monetary policy choices?

Central bank independence has become increasingly popular. Many governments have taken steps to depoliticise monetary policy choices and to hand over important powers, such as setting interest rates, to central bankers. One of the main advantages, it is argued, is that politicians are no longer able to manipulate monetary policy choices in order to try and affect their popularity and their chances of being re-elected. The policy announcements of central bankers are said to be more credible because they do not have the incentive to deviate from their announced policy. For instance, the low inflation announcements of elected policy-makers lack credibility because politicians have an incentive to inflate the economy and so boost growth and employment prior to the election.

The incentive for a pre-election dash for growth means that the general public are reluctant to bargain for low wage increases in case policy is loosened or is looser than it should be given the prevailing economic climate. In this case, it might mean that interest rates are lower than they would otherwise be in the run up to the election. In order to protect their spending power households bargain for higher wage increases than they would if the policy announcements could be trusted. In contrast, the low inflation announcements of central bankers have credibility and so inflation will be lower. In terms of economic jargon, central bank independence will reduce inflation bias as well as promoting economic stability.

Blanchflower questions whether the path of interest rates in the UK between 1997 and 2007 would have been materially different should the Treasury have been setting interest rates rather than the MPC. But, he believes that:

Interest rates would probably have been higher in 2007 as the housing boom was ranging and house price to earnings ratios approached unsustainable levels. Alistair Darling has made it clear he would have cut rates earlier in 2008, if it had been left to him….

Blanchflower argues that part of the reason that the Treasury might have made better choices in the more recent past is the narrow remit of the Bank of England to target inflation. He argues:

Now is the time to consider switching to a dual mandate that would include growth, which would give much needed flexibility.

Blanchflower calls into question the idea that targeting inflation alone can bring stability. The recent past he argues simply dispels this notion. To help form your own views try having a read of the full article and then answer the questions below.

David Blanchflower Article
The recession deniers have gone strangely quiet this month Independent, David Blanchflower (14/05/12)

Questions