Benefits of Central Bank Independence

Monetary Policy used to be the preserve of the Government. The Government would change interest rates to meet its various economic objectives. At different times the Government would give priority to:

  • lower inflation
  • higher growth
  • targeting exchange Rate
  • and even balance of payments.

For example, in the early 1980s, the Thatcher Government increased interest rates to reduce inflation.
In 1987, after a stock market crash, interest rates were cut to boost economic growth. In 1992, interest rates were increased to 15% to try and maintain the value of the £, which was then in the Exchange Rate Mechanism ERM

Arguments for Central Bank Independence

  1. It was argued that the governments tended to make poor decisions about monetary policy. In particular they tended to be influenced by short term political considerations.
  2. Before an election, the temptation is for a government to cut interest rates. This increases economic growth, reduces unemployment and increases the political support of the party. However, this expansionary monetary policy may lead to inflation and boom and bust economic cycles. Therefore arguably, it is better to take monetary policy out of government’s hands.
  3. People have more confidence in the Central Bank, therefore 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 RPI 2.5% +/-1 (now 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, and 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. However, it was a difficult economic situation, and there were few alternatives to their policies.

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