Thus far, the Bank of England has shown itself to be much more vigorous in its pursuit of low levels of inflation than the Treasury has ever been. Where the lag between changes in the output gap and subsequent changes in interest rates had hitherto been as long as a year, under the new arrangements the changes are nearly instantaneous.
Equally, though the changes in the base rate have tended to be small, and have thus far remained within a range of 4% to 7. 5%, they have been fairly volatile, as the Bank has endeavoured to react rapidly to changes in the inflation forecast. Ultimately the success of the new arrangements will be measured by how close the inflation rate stays to the target level. Since the Bank was given operational control of interest rates, the retail price index has averaged 2. 3%, and has remained within a range of plus or minus 1% of this figure – very close to the symmetrical target of 2. 5% set by the Treasury.
By this measure, the new monetary policy framework would appear to be an unqualified success. An alternative measure of success is whether inflation expectations have been changed, and whether financial markets have enough confidence in the new arrangements to reduce the required interest payments on Sterling investments9. Measured by the expected yields on long-term government bonds and the survey responses of city analysts and trade-union negotiators, inflation expectations do appear to have held constant at around 2. 5% for some time10.
This stability of expectations, combined with the commitment to a symmetric inflation target, is extremely valuable, both in increasing the ability of the economy to absorb a shock, and in allowing businesses to make long-term investment plans with reasonable confidence in the predicted level of inflation. One concern that has arisen over the decision to grant the Bank independence is that of democratic accountability. The primary reason for establishing an independent central bank was to prevent politicians from interfering with monetary policy for short-term gain.
Nevertheless, though politicians may be short-sighted, they are the elected representatives of the people. The Bank is answerable to the Chancellor, not to Parliament, so direct ministerial responsibility for monetary policy is necessarily diminished. This has generated concern among a small number MP’s, who share John Major’s view that “the person responsible for monetary policy should be answerable for it to the House of Commons”11.
However, the decision to limit the Bank’s autonomy to merely operational freedom rather than target freedom, and the provision for the Chancellor to directly override the MPC, has largely addressed these concerns. Equally, setting a symmetric inflation target prevents the Bank from overreacting to inflation. Though the Bank’s performance thus far has been a tour-de-force of monetary prudency, it is difficult to determine whether this is due to the new monetary policy framework, or to relatively benign economic conditions reducing inflationary pressures.
It must be noted that inflation has increased relatively sharply over the last six months, principally driven by a combination of rising oil prices and high housing depreciation. Growing economic uncertainty driven by an increasingly likely war in Iraq, and its potential effect on oil prices, may erode the Bank’s ability to maintain the inflation rate at the specified level.
If the Bank proves to be ineffective in controlling inflation in less favourable economic circumstances, the concerns over whether the reduction in political control outweighs the economic gains may acquire greater importance. Equally, if more widespread economic instability starts to generate problems within EMU, and political support for joining lags as a result, the necessity of a maintaining an independent central bank to meet the Maastricht convergence criteria will disappear.
In conclusion, thus far the new monetary arrangements have stood as a triumph of economic and political expediency. However, the ability of the Bank of England to deal with major external shocks to the economy has not yet been demonstrated. Given the potential for the increasingly inevitable and immanent war in Iraq to affect world oil prices disastrously, the Bank may be put to the test sooner rather than later – its performance over the next six months may decide its future.
HM Treasury. (2002), “Reforming Britain’s Economic & Financial Policy”, First Edition, Palgrave. Grant, W. (2002), “Economic Policy in Britain”, First Edition, Palgrave. DeGrauwe. (2000), “The Economic of Monetary Union”, Fourth Edition, Oxford University Press. Various. (2000), “Developments in British Politics”, Sixth Edition, MacMillan Press. Nickel, S. (2002), “The Assessment: The Economic Record of the Labour Government Since 1997”