The Bank Of England Permitted To Decide Interest Rates

The first substantive economic policy implemented by New Labour after the 1997 election was the decision to grant the Bank of England operational independence. In an unexpected move that shocked journalists, analysts and commentators alike, the Treasury ceded responsibility for interest rate policy to the bank, subject to an externally imposed inflation target. Though the economic justification for granting the bank independence was entirely sound, in retrospect, the government’s political motives were equally as important.

Regardless of the motivation, six years later, the decision to grant the Bank of England is regarded by many, as New Labour’s most successful and expedient economic policy. The decision to grant the Bank of England operational independence was regarded as “an astonishingly bold start for a new chancellor”1. However, the idea of an independent central bank is by no means new. Many leading industrial economies had independent central banks years before Britain.

In the case of some nations, most notably Germany, the independence of the central bank and its success in controlling inflation is credited as a major factor of economic success. The argument that the Bank of England should be independent had been gaining strength with economic commentators since the late 1980’s, especially in the wake of the high inflation experienced during the Lawson boom. The economic case for central bank independence is fairly clear.

In order to control inflation, it is necessary to reduce the inflation expectation of wage and price setters. Therefore, the credibility of a central bank’s commitment to combating inflation is critical. If a central bank has a poor record in fighting inflation, wage and price setters are likely to distrust its forecasts, and thus will consider overestimating inflation as less risky than underestimating it. The result is a high expectation, and thus, high inflation.

To reduce the inflation expectation today, price and wage setters have to be confident that future inflation will be low. The best way to induce this confidence is for the central bank to commit itself to achieving low inflation, and to be seen to be adhering to this target. A central bank that is seen to be hell-bent on achieving low inflation, gives wage and price setters the confidence to constrain their inflation expectations. Therefore, a central bank can achieve low inflation only if its commitment to inflation is credible.