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.
Documents
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
Articles
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)
Questions
- Why would monetary policy be expected to be more credible under an independent central bank?
- How might a lack of credibility over monetary policy affect the economy’s rate of inflation?
- Outline the advantages and disadvantages of the changes to the Bank of England’s remit.
- Central bank independence constrains discretion over monetary policy. Should governments constrain their discretion over fiscal policy? What are the advantages and disadvantages?
- Explain how the MPC tries to affect the rate of inflation through changes in the Bank Rate?
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
- If economic growth is a good thing, why might we want to reduce the chances of policymakers manipulating policy to attempt a pre-election dash for growth?
- What do you understand by credible economic policy announcements? How might a lack of credibility affect the economy’s rate of inflation?
- What does central bank independence mean for the conduct of monetary policy in the UK? In answering this you might wish to visit the Bank of England website and read about the UK’s monetary policy framework.
- Try summarising David Blanchflower’s argument against the inflation rate remit of the Bank of England.
- What do you consider to be the possible dangers of widening the Bank of England’s remit beyond just targeting the annual rate of CPI inflation?
- Central bank independence is one way in which governments can constrain their discretion over economic policy. In what other ways can they constrain their policy choices?
- Do you think governments should have full discretion over their policy choices or do you think there should be limits?
The Brazilian economy is an emerging superpower (see A tale of two cities), but even its growth slowed in the second quarter of the year, although the economy still appears to be growing above capacity. In reaction to that latest economic data, the central bank slashed interest rates by 50 basis points to 12%. The Central Bank said:
‘Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed up, for example, by large and widespread reductions to the growth forecasts of the main economic regions.’
Rates had previously been hiked up 5 times in the year to tackle rising inflation, which has been some way above its inflation target. Such tightening policies have become commonplace in many emerging economies to prevent overheating. However, following this reversal of policy, questions have been raised about the independence of the central bank, as some politicians have recently been calling for a cut in rates, including President Rousseff himself. As Tony Volpon at Nomura Securities said:
‘They gave in to political pressure. The costs will likely be much higher inflation and a deterioration of central bank credibility…It has damaged the inflation-targeting regime.’
Many believe the rate cut is premature and the last thing the economy needs given the inflationary pressures it’s been facing. Huge spending cuts have been announced to bring inflation back under control, together with the previous rate rises, so this cut in interest rates to stimulate growth is likely to put more pressure on costs and prices. Only time will tell exactly how effective or problematic this new direction of monetary policy will be.
Brazil’s growth slows despite resilient consumers Reuters, Brian Ellsworth and Brad Haynes (2/9/11)
Brail in surprise interest rate cut to 12% BBC News (1/9/11)
Rousseffl’s ‘Risky’ rate cut means boosting Brazil GDP outweighs inflation Bloomberg, Arnaldo Galvao and Alexander Ragir (2/9/11)
Brazil makes unexpected interest rate cut Financial Times, Samantha Pearson (1/9/11)
Brazil rate cut stirs inflation, political concerns Reuters (1/9/11)
Questions
- What is the relationship between the macroeconomic objectives of inflation and economic growth?
- Why are there concerns that the recent reduction in the interest rate may worsen inflation? Do you think that a decision has been made to sacrifice Brazil’s inflation-targeting regime to protect its economic growth?
- Why are there questions over the independence of the central bank and how will this affect its credibility? What are the arguments for central bank independence?
- Growth in Brazil, although lower this year, still remains very strong. Why has the Brazilian economy been able to continue its strong growth, despite worsening economic conditions worldwide?
- What type of inflation are emerging economies experiencing? Explain how continuous hikes in interest rates have aimed to bring it back under control.
- What is meant by overheating? How will the central bank’s past and current policies contribute towards it?
According to political business cycle theory, incoming governments tend to take harsh measures at first, when they can blame the cuts on the ‘mess they’ve inherited’ from their predecessors. And then two or three years later, as an election looms, they can start spending more and/or cutting taxes, hoping that the good will this creates will help them win the election.
So are we seeing the start of a new political business cycle with the start of the new Coalition government? The following two articles look at the issue.
Coalition will inflict cuts now and spend later to win a second term Guardian, Larry Elliott (17/5/10)
If you get all the bad news out at once, the only way left to go will be up. Or will it? Independent, Sean O’Grady (18/5/10)
Questions
- Explain what is meant by the ‘political business cycle’.
- Would the existence of a political dimension to the business cycle amplify or dampen the cycle, or could it do either depending on the circumstances? Explain.
- Does the existence of an independent central bank eliminate the political business cycle?
- Will the new Office for Budget Responsibility (see Nipping it in the Budd: Enhancing fiscal credibility?) help to eliminate the political business cycle? Explain your answer.
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.
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.