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The authors would like to thank Leonardo Bartolini, Sharmini Coorey, Michael Deppler, Bob Ford, Zenon Kontolemis, Lars Svensson, and European I Department seminar participants for helpful discussions.
See, among others, articles by Budd, Bean, and Artis, et. al. in “Policy Forum: The New Monetary Policy Framework in the U.K.”, Economic Journal, 108, November 1998. See also Lane and Van Den Heuvel (1998) for an empirical examination of the impact of inflation targeting in the United Kingdom.
Arguments in favor of rules over discretion are typically based on the notion that monetary policy has an inherent bias in favor of inflation (Kydland and Prescott, 1977): policy makers have an incentive to exploit the difference between the short-run and the long-run trade off between inflation and unemployment through surprise inflation. Anticipating such policies, forward looking agents raise their expectations of the inflation rate in setting wages and prices, thwarting the ex post positive effect on output. Inflationary bias could also be associated with political business cycles or attempts to collect inflation tax. The relevance of the concept of an inflationary bias and the dominance of rules has been questioned on a number of grounds. First, in general pre-set rules would be inferior to discretion in the absence of bias arising from the institutional setup, as policy makers would always have the option of following the policies that a rule would prescribe. Second, to the extent that wages are adjusted at intervals shorter than the time it takes monetary policy to actually affect inflation, the credibility issue may not be significant (see Goodhart and Huang, 1998). Third, several observers have denounced the premise that the authorities, as a rule, aim for a level of output above its potential level, which creates surprise inflation (see Bean, 1998, Goodhart, 1998, Blinder, 1997).
A possible example is monetary policy during the last year of the previous government, when the Chancellor persistently declined to raise interest rates, despite recommendations by the Governor to the contrary. Of course, it is only with hindsight that one might be able to decide whether these were politically-motivated decisions or whether they were justified by economic prospects. See Lane and Samiei (1998), on the impact of monetary policy disagreements under the previous regime.
The Bank’s non-executive members of Court are assigned the task of implementing an external evaluation of the MPC’s performance in this regard (see the Bank’s Annual Report).
Moreover, to the extent that the policy shocks are not fully anticipated, removing these would also result in lower output variability. Surprise inflation linked to government elections could also result from uncertainty regarding the election outcome. As the inflation-unemployment preference of a new government depends on this unknown outcome, with preset nominal wages based on expected inflation, real wages will turn out to be either higher or lower than their equilibrium level. In this setup, transferring monetary policy to an independent central bank would eliminate the policy uncertainty and the associated variability in inflation and output (Alesina and Gatti, 1995).
It is, therefore, possible that independence and low inflation both have a common cause (for example increased public concern over the cost of price instability). See Eijffinger and de Haan (1996) for a survey of these studies. Moreover, evidence does not seem to indicate a correlation between independence and output instability (as predicted by the conservative central banker model, see below), and there is little evidence that independent central banks face lower output costs of disinflationary policies, in spite of their presumably higher credibility. Correlation between central bank independence and political budgetary or monetary cycles also appears to be weak (Posen, 1998).
See also SM/97/256.
One set of estimates for the United Kingdom used frequently by the private sector sets wi and w2 equal to 0.5—in effect, a nominal income target—and assumes the neutral rate of interest at 3.5 percent.
It is also difficult to use these rules to draw conclusions regarding the appropriateness of a policy path ex post, because they are estimated using actual historical policy decisions.
It should be noted that while this may help explain gradual interest rate adjustments, there would be no smoothing as defined above. See Sack (1998a) for an empirical analysis of this phenomenon for the US.
The latter argument has been developed further by Sack (1998b), to explain a policy of interest rate smoothing. With every step, the monetary authority gains insight into the interest rate effect at the new level. The reduced uncertainty allows it to move further. It also follows that after a period of relatively large interest rate changes, new shock can be met with larger interest rate adjustments, as recent information is still available on the effects of a range of interest rates.
In early November 1998, expectations of three-months market rates derived from options prices were for a gradual decline from 7¼ percent to about 5½ percent by the third quarter of 1999. By early February 1999, reflecting the stepwise lowering by the MPC of the repo rate, rates had indeed fallen, to 5¾ percent, and a further lowering was expected over the next half year, to between 5 and 5½ percent. Further cuts of the repo rate in February, April, and June have since validated this expectation (see the Inflation Reports of February 1999 and May 1999).
H.M. Treasury (1998).