The Economics of Independent Central Banks

by George Hatjoullis

The economic logic behind independent central banks is that inflation is a purely monetary phenomenon and hence price stability is to be achieved only through monetary policy. Independence ensures that price stability is the unwavering objective of monetary policy and not subject to short-term expediency to meet the electoral needs of the government of the day. Independence is thus said to ‘anchor’ inflation expectations at the target level and thus also to anchor inflation.

The monetary nature of inflation is a not entirely uncontroversial assertion. It is certainly true that sufficiently tight monetary conditions can contain inflation, albeit at possibly horrendous cost to the real economy. The evidence of today however suggests that the monetary toolkit is not quite adequate to halt deflation.  There is an asymmetry in the effectiveness in monetary policy which is ironic as, if anything, central bankers have, in the post war period, been biased towards undershooting inflation targets. This bias was born of the post war experience which led to the mistaken belief economies were always more prone to inflation. As I have discussed in earlier blogs, this post-war inflation bias was arguably a feature of the specific real economy conditions that prevailed during this era and  somewhat undermines the notion that inflation is a purely monetary phenomenon. Nevertheless one should not underestimate the value of CB independence.

The Bank of England has operational independence, a specific inflation target, and well-defined procedures for reporting to the Treasury any material deviations from the target. The Governor is accountable to the Chancellor for failing to meet the target. In effect the Governor is accountable for operational competence subject to the tools available. The UK economy has been undershooting the CPI target for some time but there is no evidence that the BoE has been operationally incompetent. It has done what it can within the limits of available policy. It would have needed to adopt monetary financing to do more and this would have been controversial and would almost certainly have required Treasury approval.

In the process of assessing monetary policy the Bank must analyse the UK economy and have views on major developments. One such development is the prospect of leaving the EU and the economic consequences of the uncertainty in the interim as exit is negotiated. There is no way the Bank could have concluded other than these consequences would be negative. This was not ‘interference’ but economic logic. Monetary policy has deliberately depressed bond yields and this has had consequences for asset holders and in particular pensioners and pension plans. Monetary policy always has unintended and undesirable distributional consequences. But then so does deflation and inflation. The bank can only use the tools available and live with such consequences. The criticism of the Bank by the PM and the Brexit camp is malicious and unwarranted. It is also dangerous.

Any criticism of the Bank beyond operational competence undermines its independence. This risks de-anchoring inflation expectations and thus inflation. A pick-up in inflation would be welcome but such de-anchoring is dangerous. The collapse of sterling, a direct consequence of the EU referendum, has inflicted an inflationary shock on the economy. It is vital that the amplitude of this shock is damped. If it is magnified then inflation could become a problem once again. Inflation expectations will play a key role in whether the shock is amplified or damped. It is vital that the operational independence of the BoE is reaffirmed in order to keep expectations anchored. The political interference from the government and the Brexit camp risks compromising CB independence and destabilising the inflation outlook.