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Prepared by Jan Kees Martijn and Hossein Samiei.
See Lane and Van Den Heuvel (1998) for a comprehensive description of the new regime.
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 monetary policy disagreements under the previous regime.
The Bank has not made available the model it uses for forecasting but it intends to do so in the near future. At the same time it has made it clear that off-model considerations contribute significantly to the forecasts.
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).
One set of estimates for the United Kingdom used frequently by the private sector sets w1 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 them to draw conclusions regarding the appropriateness of a policy path ex post, because they are estimated using actual historical policy decisions. This is only partially remedied by the fact that in assessing the hypothetical performance of a particular rule, if applied in practice, independent criteria, for example in terms of the implied output variability, may be set (see for example Blake and Westaway, 1996).
Moreover, to the extent that the policy shocks are not folly 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).
See also SM/97/256.
See Eijffinger and de Haan (1996) for a survey of these studies.
The latter hypothesis was tested by comparing the sacrifice ratios associated with disinflations for central banks with different degrees of independence. See Fischer (1996).
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.