Friday Flyer: Dependence Day for the `The Old Lady'?
I start this new series of end-of-the-week blogposts with a small confession. Many years ago I was at the Bank of England working in monetary analysis the day that operational independence was granted by the incoming Labour administration. I was hugely excited and the news was treated as a heroic victory that did not so much represent the end of monetary history but a start, or at the least a renaissance.
It would not perhaps be overstating the case to say that the Bank, rather than looking for purpose by filling its time with long and variable advice, could now act. Indeed it could act, with responsibility and accountability in pursuit of an objective set by politicians, to stabilise inflation and by implication the economy.
Economic theory and a considerable body of evidence had suggested that the absence of a `credible commitment' by the monetary authorities, a collective noun that includes both the finance ministry and the central bank, to price stability would induce a positive (and economically costly) bias to equilibrium inflation outcomes. This is because smart households and firms would calculate the likely responses of these monetary authorities to booms and busts and guess that on average the monetary authorities would try to push the economy above its natural level and so induce a sustained inflation.
On the other hand an independent central bank with a target for price stability was widely thought to be the way to establish such credibility because the central bank would not have any other way to establish its reputation than to hit its designated target. A central banker would not seek re-election and would therefore not need to engineer a boom by trading-off the bank’s inflation objective against some other base objective like popularity.
Later on I co-wrote a paper on the impact of that surprise announcement in which we found that the large fall long term interest rates on the announcement of central bank independence can solely be explained by the perception that the new Monetary Policy Committee at the Bank of England would be determined to hit their given inflation target. Indeed we went on to argue that the granting of operational central bank independence was one of the clearest signals available to elected politicians about their preferences on the control of inflation.
And yet we find that this great prize is under threat in post-referendum Britain by politicians arguing that monetary policy should become come under more democratic control. Such a move would be very damaging in normal times but might be devastating in choppy post-referendum waters.
It is critical that the temporary inflation that will follow that large depreciation in sterling simply allows the economy to adjust to its new trading relationships outside the European Union, implying both lower income and terms of trade. The problem will be if this temporary inflation unhinges plans and both firms and households start to treat the increase in inflation as more persistent.
The imminent increase in inflation would be the third bout of significantly high inflation since the start of the financial crisis, the earlier episodes did not unhinge those inflation expectations but neither were they accompanied by question-marks over the continuing operational independence of central banks. If those inflation expectations do unhinge it will not be possible for the central bank not to act with higher interests and these will tend to exacerbate the expected slowdown in activity.
So why have we arrived at the point where elected politicians are introducing noise into that signal? The financial crisis has shown that independent central banks cannot prevent a bust but also that they cannot conjure up a recover. The same crisis, it is said, has increased the sense of inequity in the country at large with the discontented and excluded suffering disproportionately under the ultra low interest rate policies being pursued. Finally it said that before and after the referendum, unelected central bankers should not interfere in the political dynamic of an election.
To the first charge, monetary policy must plead guilty but it was never the case that monetary policy can affect longer terms outcomes: it is all about smoothing the path from one point to another. On the second point any change in interest rates will have distributional consequences as it affects borrowers and savers in opposite ways but on average we tend to think that interest rate cuts are expansionary overall and that is what matters.
And on the final charge Bagehot's famous points on the English Constitution may be actually be quite apt in considering the role of a central bankers, who it seems to me have the right to be consulted, the right to encourage and the right to warn. Politicians should, of course, set targets according to some social welfare function but independent central bankers must be allowed to pursue policy in the manner they see fit. Sometimes we may forget the good sense of why we once did what we did. And central bank independence is a prize worth keeping.