LET THE BANK OF ENGLAND SET THE INFLATION TARGET

The Labour government has given the Bank of England operational independence: control of monetary policy and direct accountability for hitting the inflation target. But according to Professor Anton Muscatelli of Glasgow University, writing in the latest issue of the Economic Journal, if central bank independence is desirable at all, then it is better to give the bank full independence so that it can set its own inflation targets.

Muscatelli notes that recent research on the conduct of monetary policy has stressed the positive virtues of having an independent central bank. Countries with more independent central banks have, on average, experienced lower inflation in the post-war era, and especially since the late 1960s.

The most obvious advantage of a fully independent central bank is that it is not influenced by electoral deadlines so it can take a longer term perspective on the problem of inflation control. Another related advantage is that, having a longer-term horizon than the average government, an independent central bank can build up a reputation for sound monetary policy over time.

On the other hand, Muscatelli notes, some problems may arise when monetary policy is delegated to an independent central bank, especially when the central bank’s preferences are uncertain. Two conclusions emerge from his theoretical analysis: one, independent central banks may not always be desirable; but two, if they are desirable, it is better to give them full independence so that they set their own inflation targets.

First, in countries where there is a low degree of consensus over the relative merits of maintaining low inflation as opposed to stabilising output and employment, the central bank governor or council may have very different preferences from those of the median voter. This means that an unelected central bank may have different aims from those of an elected government. The result is a degree of inflation control and output stabilisation that is sub-optimal from society’s point of view.

A natural implication is that central bank independence cannot be imposed when there are sharp divisions in society over the relative merits of low inflation and stabilisation policy. This explains why independent central banks have emerged in countries where there is a stronger consensus on the costs of inflation (such as Germany and the United States), and why institutional design as a universal approach to tackling the problem of high inflation has been overstated.

The second key conclusion is that, when an independent central bank does turn out to be desirable from society’s point of view, mechanisms have to be put in place to make the central bank accountable. Examples include setting explicit inflation targets for the central bank to meet, and the use of contracts where central banks are penalised for poor performance. But uncertainty in the central bank’s desired economic objectives means that it is difficult to design such targets and contracts.

It has been suggested that greater information disclosure is a solution to the problem of uncertain central bank preferences. Forcing the central bank to give as much information as possible to the public on anti-inflation policy (through such publications as the Bank of England’s ‘Inflation Report’) helps to solve the problem by revealing the central bank’s position on inflation policy.

Muscatelli argues that an alternative mechanism to reduce the distortion from the existence of uncertain central bank preferences is to grant the independent central bank goal independence: the central bank should be allowed to set and announce its own inflation targets.

He shows that the central bank has an incentive to reveal its preferences through setting the inflation target. Accountability may then be achieved through full independence. Arguably, economies where the central bank has operational independence but not goal independence (such as the UK, Canada and New Zealand) may not be reaping the full benefits of central bank independence.

Note: ‘Optimal Inflation Contracts and Inflation Targets with Uncertain Central Bank Preferences: Accountability through Independence?’ by V. Anton Muscatelli is published in the March 1998 issue of the Economic Journal. Muscatelli is Professor of Economics at Glasgow University. Further work of his in this area includes 'Political Consensus, Uncertain Preferences and Central Bank Independence' and 'Inflation Contracts and Inflation Targets under Uncertainty: Why We Might Need Conservative Central Bankers', Glasgow University Departmental Discussion Papers, available on the web at: http://www.gla.ac.uk/Acad/PolEcon/.

For Further Information: contact Anton Muscatelli on 0141-330-5062 (fax: 0141-330-4940; home: 0141-942-0090; email: V.Muscatelli@udcf.gla.ac.uk) or RES/ESRC Media Consultant Romesh Vaitilingam on 0171-878-2919 or mobile 0468-661095.