THE COST OF CENTRAL BANK INDEPENDENCE:

BIGGER ECONOMIC DOWNTURNS NEEDED TO FIGHT INFLATION

New Zealand’s bold reform of its central bank in 1989 has been widely influential, largely because the country successfully reduced its high inflation and has been able subsequently to maintain a low inflation rate. But findings by Professors Michael Hutchison and Carl Walsh, published in the May 1998 issue of the Economic Journal, indicate that reducing inflation has not been the only effect of the institutional reforms that transformed the Reserve Bank of New Zealand. The trade-off between short-run economic fluctuations and inflation has also been altered with the consequence that much bigger downturns will be needed in future to reduce inflation.

According to Hutchison and Walsh’s results, New Zealand faces a quite different output-inflation trade-off than it did prior to the central bank reforms, with fluctuations in economic activity now associated with much smaller movements in inflation. This means that the ‘sacrifice ratio’, the output or unemployment cost of reducing inflation, is larger: when changes in output lead to only small movements in inflation, a larger economic downturn is needed to lower inflation significantly.

To determine whether the central bank reforms fundamentally altered New Zealand’s short-run trade-off between output and inflation, Hutchison and Walsh employed a method designed to allow for a gradual change in the trade-off. In doing so, they found that the economic structure only began changing significantly more than a year after the reforms were instituted. It was only after the newly reformed Reserve Bank of New Zealand actually had engineered a reduction in inflation that behaviour in the economy seems to have started to adjust to the new, lower inflation environment.

Several possible explanations might account for the change in New Zealand’s short-run output-inflation trade-off. One popular view attributes an important role to credibility: more credible central banks can lower inflation through publicly announced inflation goals with smaller consequences for unemployment. This occurs because the announced policy has an immediate effect in reducing expected inflation if the central bank is credible. If increased political independence gives a central bank greater credibility in the fight to lower inflation, then inflation reductions should be associated with smaller output declines.

But this credibility hypothesis predicts that the short-run output-inflation trade-off will move opposite to what Hutchison and Walsh actually find in the data. Using several alternative measures of credibility, they do find some evidence of a credibility effect, but it appears to have been dominated by other factors working to raise the output costs of inflation changes. While their research is unable to pinpoint the exact mechanism at work, it suggests that a move towards greater central bank independence does more than just lower average inflation as most previous research had concluded.

The central banking reforms in New Zealand provide a laboratory experiment for studying the effects on the economy’s structure of major changes in the monetary policy structure. Since Europe is about to embark on a monetary policy experiment of an even larger scale, it can be expected that similar effects on Europe’s economic structure may occur.

ENDS

Note for Editors: ‘The Output-Inflation Trade-off and Central Bank Reform: Evidence from New Zealand’ by Michael M. Hutchison and Carl E. Walsh is published in the May 1998 issue of the Economic Journal. The authors are both Professors of Economics at the University of California, Santa Cruz.

For Further Information: contact RES/ESRC Media Consultant Romesh Vaitilingam on 0117-983-9770 or mobile 0468-661095; or Carl Walsh on 001-408-459-4082 (fax: 001-408-459-5900; email: walshc@cats.ucsc.edu ).