3.1.1The conduct of monetary policy

No central bank can avoid some involvement with the conduct of monetary policy.

This is because the conduct of monetary policy mustinvolve the setting of short-

term interest rates, and this is done by the central bank using its role in the money

markets, exploiting its position as banker to the rest of the banking system (see

section 5.3). However, while the setting of rates must involve the central bank, the

decision as to what rate to set may be made elsewhere. This is what used to happen

in the case of the Bank of England until the mid-1990s. The Bank of England was

formally nationalised in 1947 and from then until 1997 the level of interest rates

was determined formally by the Chancellor of the Exchequer, advised by both the

Treasury and the Bank of England. However, during the 1970s and 1980s evidence

seemed to accumulate that linked low ination with central bank independence

of government. This led to tentative steps towards giving the Bank of England more

responsibility for setting interest rates, independently of the government’s preferences.

Firstly, in November 1993, it was agreed that the Bank would have discretion in the

timingof interest rate changes, though the change itself still needed the Chancellor’s

agreement.

Next, in April 1994, it was decided that minutes of the monthly meetings between

the Chancellor and the Governor of the Bank of England should be published

promptly. It was argued that this would serve two purposes. Firstly, it would reveal

the reasons for interest rate changes and thus provide information to agents which

would enable them to make their own judgement about the future trend of interest

rates. Secondly, the minutes would reveal any difference of opinion between

Chancellor and Governor and observers would be able to see for themselves whether

short-term political considerations were entering into the decision. Thus, it was hoped,

the Chancellor would be less likely to argue for a particular interest rate decision on

‘political’ grounds and this would increase the Bank of England’s ‘credibility’ in the

ght against ination.

However, the major step towards independence came in May 1997 when it was

announced by the new Labour government that the Bank would have complete

independence in its setting of whatever interest rates were required to achieve and

maintain an ination target of 2.5 per cent (/1 per cent). The decision was placed

in the hands of a Monetary Policy Committee (MPC) consisting of nine members:

the Governor of the Bank and four other senior Bank personnel, and four specialists

appointed by the Chancellor of the Exchequer. The Governor retains the casting

vote. There is a strong emphasis on accountability, with the minutes of the MPC’s

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Chapter 3 • Deposit-taking institutions

monthly meetings (and voting record) being published, along with a quarterly Inat-

ion Reportwhich contains the evidence about inationary trends upon which the

MPC is basing its decision. Notice though that while this independence marks a

major transition from the arrangements between 1947 and 1993, it falls short of

the degree of independence enjoyed by some other central banks. In particular, the

Bank of England is limited to ‘instrument independence’ – it is free to set the level

of interest rates required to achieve a target, but the target is set by the government.

This contrasts with the instrument and‘goal independence’ of the European Central

Bank (ECB) and the Federal Reserve (in the US) which also set what they think is the

appropriate target.

Instrument independence:The freedom of the central bank to take whatever steps it

thinks necessary to achieve the goal laid down by government.

Full independence:The freedom of the central bank to choose boththe goal (usually a

target rate of ination) and the steps necessary to achieve it.

The trend towards increasing central bank independence has its origin in the

observation that there is a positive correlation between the political independence of

central banks and low rates of ination. Indicators of political independence include

such things as the role of government in appointing members of the central bank

board, government representation on the board, the length of term of the senior

bank ofcers compared with government, and the details of the bank’s charter. The

earliest work was done by Bade and Parkin (1985), who found this correlation across

twelve OECD countries. Grilli et al. (1991) extended the study by adding indicators

of economicindependence (e.g. the government’s ability to borrow from the central

bank). They found that political independence correlated with low ination in the

1970s while economic independence seemed more important in the 1980s. Later

studies (Alesina and Summers, 1993) extended the measures of independence and

the countries examined. The basic hypothesis continued to be conrmed.

The theory behind the hypothesis contained two elements. The rst is that demo-

cratically elected governments have an incentive to run monetary policy with a

bias towards ination. This is because the short-term effect of a monetary expansion,

especially if it is unexpected, is usually to reduce unemployment and increase out-

put. These are both results which impress voters and thus increase the popularity of

governments, even though the employment and output effects do not last. When

the positive ‘real’ effects have worn off, the community is left with a higher price

level and agents who expect that prices will continue to rise. Policy has then to be

switched to deation in order to reverse these expectations. Since it does not have

to appeal to voters, a central bank should be able to resist pressure for undesirable

monetary expansion.

The second argument was known as the ‘time-inconsistency’ problem and is

based on the fact that society’s wellbeing is improved by both low ination and low

unemployment. Hence, once the policy-maker has achieved low ination, he auto-

matically has an incentive to expand the economy to improve the unemployment

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