Monetary policy (mainly interest rates) used to be managed by the government. However, in recent years, there has been a trend to give monetary policy to independent Central Banks. The Central Bank officials are appointed by government and are given broad guidelines (e.g. target low inflation). But, the decisions are left to Central Bankers and not government.
Political business cycle
The feeling was that when the government was responsible for setting interest rates, there was a political business cycle. This means that the incumbent government sought to influence the economic cycle to coincide with elections.
Shortly before an election there is a temptation to reduce interest rates. This helps to boost disposable income, increase economic growth and reduce unemployment. A strong economy makes it easier for the governing party to gain re-election.
However, this loosening of monetary policy can cause the economy to grow faster than the long-run trend rate leading to inflationary pressures. Once the election is won, the government can increase interest rates to reduce inflation. If it causes a recession, there is still time for the economy to recover before the next election.
Lawson boom and failure of monetary policy
In the late 1980s, the government pursued expansionary fiscal and monetary policy, causing economic growth to exceed the UK’s long-run trend rate of 2.5%. The government felt their supply side policies had created a supply side miracle. But, the above trend growth caused inflation and the government had to increase interest rates to reduce inflation. It caused a classic boom and bust.
An independent Central Bank with inflation mandate would most likely have avoided this over-exuberance and kept growth at a more manageable level.
Arguments for Central Bank Independence
- Governments tend to make poor decisions about monetary policy. In particular they tended to be influenced by short term political considerations.
- Before an election, the temptation is for a government to cut interest rates, making boom and bust economic cycles more likely. Therefore arguably, it is better to take monetary policy out of government’s hands.
- If government has a track record of allowing inflation, then inflation expectations start to creep up making inflation more likely.
- An independent Central Bank may have more credibility. If people have more confidence in the Central Bank, this helps to reduce inflationary expectations. In turn this makes inflation easier to keep low.
Bank of England’s Independence 1997
- In 1997, the Labour party gave the Bank of England full independence in setting Monetary Policy. However the government did give the Bank of England an inflation target of CPI 2% +/-1
- If the inflation rate goes outside this range the Bank of England has to write an explanatory note to the chancellor.
- Between 1997-2007, the Central Bank did a reasonably good job in keeping inflation low, enabling a long period of economic expansion. From 2007-2011, the Bank struggled with the combination of credit crunch, deep recession and cost push inflation.
- In 2010 and 2011, the Bank had to tolerate inflation going above target (e.g. CPI inflation 5.2% in October 2011) because of the risk of pushing the economy back into a double dip recession. It was a difficult economic situation with few alternatives.
Bank of England and Quantitative Easing
The 2009 recession was so serious that cutting interest rates failed to boost economic growth, therefore the Bank of England pursued unconventional monetary policy of quantitative easing. This involved creating money and buying government bonds. The aim was to reduce interest rates and increase money supply. It is quite controversial because
- Involves creating money ‘printing money’ with risk of creating future inflation
- Makes the bank more political, e.g. decision to buy government bonds arguably helps the government to borrow more at a lower interest rate cost.
- Benefits of quantitative easing mainly go to top financial firms and bankers. Only small fraction of extra money filtered through into loans for small companies.
However, the policy helped to offset the deflationary impact of government spending cuts. It gave the UK greater flexibility compared to Eurozone
There is concern that quantitative easing has unwarranted side effects on equity. With Q.E. Pushing up asset prices and helping to make the rich richer.
Concerns over independent Central Banks
- Stick rigidly to wrong targets. The ECB has been criticised for sticking too rigidly to the target of low inflation, when Europe has much bigger problems of unemployment and low economic growth.
- Economic policy set by unelected officials.
- Concerns on wide impact of monetary policy, e.g. impact of low interest rates on distribution of income between savers and borrowers.
- Since Central Banks were made independent there has been a change in economic climate. Inflation and booms are no longer major issue. Instead issue is one of secular stagnation and prolonged liquidity trap.
Since the Bank of England was made independent in 1997, it has been widely regarded as better than the alternative (e.g. Chancellor setting interest rates and monetary policy) There are valid concerns about equity effects of monetary policy, but there are ways for the government to deal with these – other than taking back control of monetary policy.
Although Central Banks are independent, it is important to bear in mind, that the targets can be reset. Arguably, the ECB should be given wider brief than just focusing on inflation.
- An evaluation of the MPC in controlling inflation
- Criticisms of Bank of England
- ECB v Bank of England
- UK Monetary Policy
- Bank of England – monetary policy (external link)