changes in uk monetary policy: rules and discretion in practice

ELSEVIER Journal of Monetary Economics 39 (1997) 81-97

JOURNALOF Monetary ECONOMICS

Changes in UK monetary policy: Rules and discretion in practice

M e r v y n King *

Bank o/' En.qland, Threadneedle Street, London E(2R BAH, UK

Received 1 March 1995; final version received 1 January 1997

Abstract

In October 1992, following sterling's departure from the Exchange Rate Mechanism, Britain adopted a new framework for monetary policy. That comprised two components: first, an explicit target for inflation, and, second, institutional changes designed to give greater influence to the Bank of England by increasing the transparency and openness of the process by which interest rates are set. This paper analyses those changes l¥om the perspective of the debate on rules versus discretion, and argues that an appropriate design of institutional arrangements can provide incentives for central bankers to pursue the first-best state-contingent monetary policy.

Key words': Inflation target; Bank of England; Inflation; Monetary policy J E L classification: E50; E52; E58

I. Introduction

Over the three hundred years since the Bank of England was founded in 1694, the average rate of inflation in Britain has been 1.4%. But in the period since the second world war, inflation has averaged 6% and between 1965 and 1980 it averaged no less than 10.3% (see Fig. 1). Since 1945 prices have risen more than twenty-fold. Creeping inflation in the 1950s and early 1960s led to rapid inflation in the 1970s, reaching a peak of 27% in August 1975, before a gradual

disinflation during the 1980s and 1990s.

* Tel.: 44-171-601-4963; fax: 44-171-601-3047.

This paper was prepared for a conference hosted by the Swiss National Bank in March 1995. The views expressed are those of the author and are not necessarily shared by the Bank of England.

0304-3932/97/$17,00 © 1997 Elsevier Science B.V. All rights reserved. P11S0304-3932(97)00009-3

82 M. King~Journal of Monetary Economics 39 (1997) 81-97

- - - - 3 0

- - - - 2 8

- - - - 2 6

- - - - 2 4

- - 2 2

- - 2 0

- - 18

- - 16

- - 14

- - 12

- - I 0

- - 8

- - 6

- - 4

- - 2

I I - - 0

1945 5 0 5 5 6 0 6 5 7 0 7 5 8 0 8 5 9 0 9 5

Fig. 1. Inflation in Britain, 1945 96. Inflation is measured by the annual increase in retail prices (excluding mortgage interest payments) in the twelve months to December of each year. Source: Office for National Statistics publication Retail Prices, 1914-1990 (first published 1991 ) and ONS Business Monitor MM23 - Retail Prices Index (various issues).

That post-war inflation was out o f line with past experience. It reflected a belief, held at the time by many economists both inside and outside government, that monetary policy could exploit a long-run trade-off between inflation and output (King, 1996b). The absence o f a credible monetary regime is shown by the instability o f the short-run Phillips curve in the post-war decades, as can be seen in Fig. 2. For the post-war period as a whole, there was neither a long- run trade-off between unemployment and inflation, nor a stable natural rate o f unemployment (see the lower panel o f Fig. 2). Over the past twenty years, the history o f monetary policy in the UK has been a search for a nominal framework that would provide both an anchor for the price level and some credibility for the government 's commitment to low inflation. Targets for the monetary aggregates were introduced in the 1970s, first for broad money and subsequently for narrow money. Large and unpredictable changes in velocity led to the abandonment of these targets in the mid-1980s. Attention then switched to the exchange rate, first with an informal target against the Deutsche mark (DM) and then with full membership o f the Exchange Rate Mechanism (ERM), with its explicit exchange rate target expressed in terms of narrow bands against other European currencies.

Britain joined the ERM in October 1990 and was forced to abandon its membership two years later on 16 September 1992. During that period the conflict

M. King~Journal o f Monetary Economics 39 (1997) 81 97 83

1950-59 l0 _Percent

798--- 1 9 5 ~ 9 5 2

.I 6 -

~ 5 -

3 - ~ 9 5 8

2 - 1954"

1 - ~ 1959 0 . . . . . . ~ . . . . i

0 0.4 0.8 1.2 1.6 2

Unemployment rate (per cent)

1970-79 30 _Per cent 2 8 - 2 6 - 2 4 - 2 2 - 2 0 -

.! ]8 - ~. 1 6 - --~ 1 4 -

1 2 - I 0 - 8 - 6 - 4 - 2 - 0 I i

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1975

1 9 7 ~ 9 7 6

1 9 7 ~ : 97f 97~1197~ 7

a

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1960-69 7 -Per cent

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196 1969

1968

0 i i i i u i o l '2 '3 '4


1 9 8 0 - 8 9 20 _Per cent 1 9 - 1 8 - 17 - 1 9 8 ~ N N ~ 1 6 - 1 5 - 1 4 - 13 - "~ IORI 1 2 - \ 11- 1 0 - 9 - ~ 8 2 8 - 7 - 6 - 1 9 8 ~ _ 19~1~1985 5 - 1 9 ~ 2 ~ - , ~ 984 4 - 3 - 19b"7 11986 2 - I -


1 9 9 0 - 9 6

10 - Per cent

9 - 1990

7 -

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3 - 1996 t ~ l ~ ~ 1993

Y 2 - 1994 1 -

0 2 4 6 8 10 12 Unemployment rote (pet cent)

POST-WAR PERIOD: 1950-96 26 - Per cent

24_ • 22 - 20 - 18- 16 - • wmw

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6 - • •

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Source: King (1996)

Fig. 2. I n f l a t i o n - u n e m p l o y m e n t t r ade -of f s in the U K , 1 9 5 0 - 9 6 .

84 M. Kiny/Journal of Monetary Economics 39 (1997) 81 97

between domestic and external constraints became increasingly severe. Following the rise in inflation in the late 1980s, short-term interest rates were raised to 15%. That led, with a lag, to a sharp disinflation. After Britain joined the ERM, domestic considerations pointed to the need for lower nominal interest rates, but the consequences of German unification were posing a dilemma for the ERM as a whole. Following that shock to the German economy, a rise in the real exchange rate was necessary in order that output could be switched from net exports to meet the increased domestic demand resulting from unification. The required rise in the real exchange rate could have been brought about by either an appreciation of the DM within the ERM or higher inflation in Germany than elsewhere. The system as a whole failed to deliver the former, and, with the commitment to price stability in Germany, the latter could be achieved only by extremely low inflation in other ERM countries. In the absence of a DM appreciation, German interest rates were increased, and the level of short-term interest rates consistent with membership of the ERM was higher than was appropriate for the domestic economy in the UK.

Following departure from the ERM, it was necessary to base monetary policy on an appropriate domestic target. After discussions between the Treasury and the Bank of England, a new monetary policy framework was announced in October 1992, which had two components: (1) interest rates would be set in order to achieve an explicit target for inflation (currently 2.5% a year or less) some two years or so ahead; (2) a number of institutional changes (described in more detail in Section 3) were made which gave a greater role to the Bank of England in the setting of interest rates. Those changes have increased the transparency and openness of the monetary policy process. The Bank of England is not independent in the sense that it has the power to set interest rates. That remains the prerogative of the Government, in the person of the Chancellor of the Exchequer. But the Bank's view on the desirable level of rates is made known publicly after the monthly monetary meetings now held between the Chancellor and Governor (and their senior officials) at which interest rates are set. The Bank has independence of voice but not of action.

Inflation has remained low since the new framework was introduced, although it has been below the current target level of 2.5% for only ten months, and at the end of 1996 was 3.1%. Unemployment fell from its cyclical peak of 10.5% in December 1992 and January 1993 to 6.7% at the end of 1996. It is too early to draw firm conclusions about the impact of the inflation target on the level and stability of inflation in the UK. But the change in the role of the Bank of England does, I think, offer some insights into the impact of institutional arrangements of the incentives of monetary authorities to pursue price stability, and the extent to which that can best be achieved by the use of a rule or the exercise of discretion.

In this paper I try to relate these recent changes in the monetary policy process in the UK to the literature on rules and discretion. I shall argue that attention

M. King~Journal of Monetary Economics 39 (1997) 81 97 85

should be paid to the incentives facing central bankers, and, in that context, transparency and openness have a major role to play. In Section 2 of the paper, a simple model of monetary policy to review the trade-off between rules and discretion is set out. Both a non-contingent rule and the exercise of discretion are dominated by the optimal state-contingent 'rule'. I present a simple diagram to illustrate the differences between these monetary policy regimes, and show how Rogoff's (1985) conservative central banker relates to those equilibria. Section 3 describes the new monetary policy framework adopted in October 1992 and explains how the institutional changes have worked. Section 4 attempts to explain why this new regime possesses some of the characteristics of the optimal state- contingent monetary policy rule.

2. The trade-off between rules and discretion

The choice between rules and discretion has been central to the academic literature on the conduct of monetary policy since Simons (1936). The insight of Kydland and Prescott (1977) was that the exercise of discretion entails a cost - the inflation bias that results from the anticipation by private-sector agents of the attempt by the monetary authorities to target output in excess of the natural rate. Against that cost must be set the benetits of flexibility to respond to shocks and achieve a more stable path of output and employment. In principle, there is an optimal state-contingent rule which combines the benefits of precommitment to a monetary rule with the advantages of flexibility. But, if monetary policy is a sequence of one-period decisions, then there is an incentive for the authorities to deviate from the optimal policy response, and such behaviour will be anticipated by the private sector. In such circumstances there is a trade-off between the gains from dynamic consistency and the loss of flexibility in imposing a monetary rule, and the choice for central banks is between a (typically simple) non-contingent rule and the use of complete discretion.

Central bankers have been largely unmoved by the debate on rules versus discretion, in part, no doubt, because they wish to expand the area of their own discretion, and in part because few, if any, domestic rules have proved stable. Simple monetary rules have proved inadequate in a number of countries where velocity shocks have been large and unpredictable. As Simons (1936, p. 5) him- self put it, "The obvious weakness of fixed quantity [of money], as a sole rule of monetary policy, lies in the danger of sharp changes on the velocity side". Nevertheless, it is widely agreed by academics and practitioners alike that greater predictability of monetary policy is desirable. In Simons' (op. cit.) words agaim "we must avoid a situation where every business venture becomes largely a speculation on the future of monetary policy". But posing the problem in terms of a stark rules versus discretion dichotomy can divert attention from the issue of how to design the structure of incentives facing the central bank.

86 M. Kin O/Journal of Monetary Economics 39 (1997) 81 97

The trade-off between rules and discretion can be illustrated by the following simple and very standard model (with all variables apart from inflation expressed in natural logarithms). I shall recast the model somewhat to draw out the link between an inflation target and the conventional discussion of monetary policy. Output is denoted by y, and its value at the natural rate of unemployment by y*. The inflation rate is denoted by ~. In a given period, output is described by the reduced-form supply function

y = y * + b ( z t - ~ ) + e , (1)

where z~ is the private sector's expected rate of inflation and the b > 0 shock is white noise with zero mean and variance a 2. I f we assume a constant velocity of circulation and normalise the previous period's price level to unity, the money stock, m, is given by

m=zt + y. (2)

The preferences of the representative agent are given by a loss function defined over quadratic terms in inflation and output. The desired level of inflation is zero, and the target level of output, ky*, exceeds the natural rate of output.

L_~aETr 2 + E(y - ky*) 2, (3)

where a > 0 and k > 1, and E(.) is the expectations operator. The assumption that k > 1 is crucial to the existence of an inflation bias under discretion. It may be justified by the existence of distortions to the natural rate of output, resulting perhaps from taxes, which it would be costly to eliminate by other policy instruments.

Each period the money supply is set by the central bank in full knowledge of the size of the shock (the realization of e). The expectations of the private sector are, however, formed before E is observed. In this setting it is possible to analyse a number of different regimes for monetary policy. The first is the optimal state-contingent rule which could be implemented only if the private sector could verify that the central bank was following the rule, or in which the central bank has a long-time horizon and a low discount rate. That raises the question of how central bankers can be persuaded to act in such a fashion. The second regime is a rule which is verifiable by the private sector, and hence is not state-contingent. The third regime is pure discretion, and the fourth is the exercise of discretion by a 'conservative' central banker (Rogoff, 1985).

Because of the linear-quadratic structure of the model, it is sufficient to consider linear monetary policy reaction functions of the form:

m = )q + 22~. (4)

! define the central bank's inflation target as the inflation rate it would choose as its objective at the expected value of the shock (a zero value of e) - the

M. Kiny/Journal of Monetary Economics 39 (1997) 81 97 87

unconditional expectation of inflation. Denote the inflation target by 7r*. From Eqs. (2) (4), the paths of inflation and output can be expressed as a function of private-sector expectations, the shock, the model parameters, and the policy reaction function which itself comprises the inflation target and a response to the shock. In general

v = y * + b ( ~ * - ~ ) + f i ~ : ,

7r = / r * jr_ g,

where fl = l + { b ( 2 z - 1 ) } { l+b} . With rational expectations ~ = x*. The monetary policy regimes differ according to the values of ~* and fi chosen by the central bank. Any monetary policy can be described as a choice of (i) an ex ante inflation target and (ii) an optimal response to observable shocks. The second aspect must be borne in mind both when choosing the inflation target and when monitoring performance against the target.

2.1. The optimal state-contingent rule

The first-best monetary policy reaction function is given by choosing values of zt* and fl to minimise the expected loss L, given only the constraint that private- sector expectations are rational and that the state-contingent rule can be enforced. Substituting (5) into (1) yields the optimal paths for output and inflation as

a Yo = v* + - - a + ~ e ,

b (6) rc o - - b2 g- a +

The optimal inflation target in this regime is zero, and there is no inflation bias. Substituting into (3) gives the optimal value of the loss function

1 Lo----z 2 + - - 0 .2 ( 7 ) 1 + 0 '

where z = (h - l)y* and 0 = b2/a. The loss function comprises two terms; the first represents the loss from the fact that output equals y* rather than ky* on average, and the second the loss from unavoidable shocks. The value of Lo is a benchmark against which other policy reaction functions may be judged.

2.2. A non-contingent rule

If a state-contingent rule is not credible - because there is no simple way to pre-commit to such a rule, for example - then the class of feasible rules reduces in this simple model to a constant money supply rule, rn = 21. The optimal policy

88 M. King/Journal of" Monetary Economics 39 (1997) 81-97

rule is determined as with the contingent rule, except that 22 is constrained to zero. It is easy to see that in this case

1 YR = Y * @ 1 ~ g, ( 8 )

1 lrR-- 1 + b e.

Again the inflation target is zero. The loss under the fixed rule is

l + a cr 2 LR ~-'~-Z 2 -~ ( f ~ -b~ 2 . (9)

The first term is identical to that under the optimal contingent policy rule, but the second is larger than the corresponding term in (7) because of the inability to respond flexibly to shocks. The rule is time-consistent (there is no inflation bias) but sub-optimal. Output is not necessarily more volatile with a simple rule than with state-contingent responses. That depends upon the weights attached to volatility of inflation and output. In fact, the simple rule leads to less variable output and more variable inflation if a > b. When this inequality is reversed so is the ranking of volatilities.

2.3. Pure discretion

With unfettered discretion there is a problem of dynamic inconsistency leading to an inflation bias. In this case the central bank chooses n* and fl to minimise L taking the expected inflation rate as pre-determined. In a rational expectations equilibrium, this expected rate must be equal to the unconditional expected inflation rate generated by the optimal discretionary policy. Output and inflation are given by

7~ D z --Z -- ". a

The inflation target (unconditional expected inflation) is positive - the 'inflation bias' of discretion. Moreover, the inflation bias is a constant, independent of the state of the world. The value of the loss function under discretion is

L D z ( I + O)z 2 (11) \ l + O J "

A comparison of (9) and (1 1) shows the trade-off between rules and discretion. The first term in the loss function is larger under discretion because of the inability to precommit credibly to a policy of price stability. The second term is larger

M. King~Journal of Monetary Economics 39 (1997) 8l 97 89

under the simple rule because of the inability to respond to shocks when they occur, The choice between a simple rule and discretion depends upon parameter wflues.

2.4. A Ro~t(~an conservative central banker

A compromise between rules and discretion was suggested by Rogoff (1985). Parliament could appoint as Governor of the central bank someone whose aversion to inflation, as described by the parameter a, was greater than that of Par- liament i t s e l f - a 'conservative' central banker. The central bank would then be left to exercise discretion. In this way Parliament could precommit to an anti- inflationary policy without giving up entirely the benefits of discretion. Denote the value of the inflation aversion parameter of the central banker by ~ and let p = a/~. Replacing a by ~ in (10) yields the outcomes chosen by the conservative central banker.

3 ' = 3 ' + c,

b I / pb/a "~ (12)

a

Substituting into (3) gives the value of the loss function to Parliament when monetary policy is determined by a conservative central banker

l+0p 2 "~a2. L c = ( I +Op2)z2+ (1 +~]~p)2j (13)

The first term is smaller than the equivalent term under pure discretion, reflecting the benefit of partial pre-commitment, while the second term is larger, reflecting the less flexible response to shocks. The optimal degree of 'conservativeness' is found by choosing p to minimize L o It is straightforward to show that the optimal value of p satisfies 0 < p < 1. Hence it is optimal to delegate control of a central bank which exercises discretion to a 'conservative' central bank governor (Lc <LD). However, at the optimal p, Lc <Le. Hence the conservative central banker determinates both a simple rule and the exercise of discretion by a "representative' central banker.

Two special cases are those of an 'inflation nutter' a governor who places weight only on inflation and none at all on output stabilisation, i.e. p = 0 and an 'employment nutter' - who targets only output and employment and places no weight at all on inflation, i.e p---+ vc. With the former, output and inflation are given by

YN--Y* +c , (14)

7C N : 0 .

90 M. Kino/Journal of Monetary Economics 39 (1997) 81-97

Price stability is the optimal policy in every state of the world, and shocks are absorbed by fluctuations in output. The value of the loss function when policy is determined by an 'inflation nutter' is

LN = z 2 + o "2. (15)

The 'employment hurter' stabilises output fully such that y = y*. But inflation increases without limit and the result is hyperinflation. There is no positive inflation rate sufficient to persuade the 'employment nutter' to stop creating inflation surprises in order to raise output. Expectations are destabilised.

The differences between these various policy regimes are illustrated in Fig. 3 which shows the loss in (z:, a 2) space. Each regime, denoted by the suffix in the expressions for the loss function shown above, corresponds to a point in Fig. 3 (apart from the 'employment nutter' when hyperinflation leads to an infinite loss). Three of the regimes - discretion (D), the conservative central banker (C) and the 'inflation nutter' (N) - lie on a curve which is the locus of all possible degrees of 'conservativeness' of the central bank governor, as given by the value of p. The iso-loss lines have slope of -1 / (1 + 0), reflecting social preferences between inflation and output volatility.

The ranking of regimes is

Lo <Lc < LR . (16)

LN

g~

~ ~-~+ o

' \ N N

\ L c \ \ I

. . . . . . . . . . . . - . N _ _ . . . . . . . . . . . . . . . . . . . . . . .

\ \ \ \\N~R \ \ \ ~ I L C

. . . . . . . . . . . . . . . . . . . . . . . .

O 1 \ \ \ \ D

I I \ \

1 INFLATION BIAS

Fig. 3. Ranking of monetary policy regimes.

M. King~Journal of Monetary Economies 39 (1997) 81 97 91

One conclusion from this ranking is that since the optimal state-contingent rule is time-inconsistent, the second-best solution is to appoint an appropriately conservative central bank governor. Such a policy dominates the use o f either a simple rule or the exercise o f discretion by a governor with representative preferences. But it may be possible to do better. In Section 4, I discuss how an inflation target may provide incentives for a central banker to mimic the optimal state-contingent rule.

3. Recent changes in the UK monetary policy framework

When Britain left the ERM in September 1992, it was necessary to put in place a new framework for monetary policy. This had two key elements. The first was an explicit inflation target. The second was a degree o f transparency and accountability unprecedented in UK monetary history, of which the most visible signs are the Bank of England's Inflation Report and the publication of the minutes of the monthly monetary meetings between the Chancellor of the Exchequer and the Governor of the Bank of England. The second element is crucial to the operation of the first. This is because transparency and accountability are seen as part of a conscious attempt to give incentives to the Bank such that its public advice will enhance the credibility o f monetary policy.

3.1. The inflation target

Following the earlier lead of New Zealand and Canada, the UK introduced an inflation target in October 1992. The objective was to achieve 'price stability' in the long run, defined by the then Chancellor as an inflation rate o f 0 - 2 % a year, where inflation was measured by the annual change in retail prices excluding the impact o f mortgage interest rates on housing costs. 1 But the aim was not to bring inflation so defined down to below 2% by the next month, or even the next year. It was to approach price stability gradually. A wide band of 1-4% for the target range of inflation was announced, with the additional objective of reaching a level below 2.5% by the end of the Parliament, a date then some four to five years ahead. The implicit assumption was that it would take approximately five years to make the transition to price stability.

In 1995 the target was modified. Monetary policy would aim consistently to achieve an inflation rate of 2.5% or less some two years ahead. Shocks (to com- modity prices or the exchange rate, for example) would mean that inflation would

t The official Retail Price index for the UK, unusually for a developed country, includes interest payments on mortgages. Hence a rise in short-term interest rates designed to reduce inflationary pressure leads to an immediate rise in measured inflation. The inflation target is, therefore, defined over the price index excluding mortgage interest payments.

92 M. KinyIJournal of Monetary Economics 39 (1997) 81-97

sometimes be above and sometimes below that figure. But in the long run, if policy were successful in achieving the target, inflation would average 2.5% or less [see King (1996a) for further discussion]. The need to look ahead derives from the lags between changes in monetary policy and their effects on inflation. An acknowledgement of those lags in the definition of the target permits tempo- rary shocks to output to be accommodated by allowing inflation to move above or below the target for a short period, while aiming continually to bring it back to the target two years or so ahead.

The design of the inflation target is clearly consistent with the model analysed in Section 2, with = * = 2.5% a year, and // set such that the effect of supply shocks on inflation dies out after about two years.

3.2. Institutions for central bank accountability

In addition to the inflation target, a crucial part of the new monetary framework was a set of institutional changes designed to enhance credibility in the government's commitment to price stability. Obviously, the most effective way to sustain credibility is a track record of low inflation - as achieved by the Bundesbank. But after the forced exit from the ERM, and the poor track record on inflation of the UK over more than twenty years, it was important to put in place measures which might increase the cost of future deviations from the commitment to the inflation target. Since October 1992, four major institutional changes have been made.

Inflation Report. In October 1992, the Chancellor asked the Bank to provide its own independent verdict on progress towards meeting the inflation target to be published in a new Bank of England quarterly Inflation Report. The first Report appeared in February 1993. Each Report reviews the wide range of economic data needed to assess inflation over the following two years or so, and provides a forecast of inflation, which acts as a focus for public assessment of monetary policy. That projection is based on the assumption of unchanged official interest rates, because it is part of an assessment of the existing monetary stance. The appraisal of the risks around the central projection is important; the Bank now presents a probability distribution for the path of inflation in chart form. If it looks more likely than not that the inflation target will be overshot in two years time, the clear policy implication is that interest rates should be raised soon.

Regular monetary policy meetings. A framework of formal monthly meetings between the Governor and Chancellor, and their senior officials, was established to review monetary policy and set the level of interest rates for the forthcoming month. These meetings are the culmination of a process by which the Treasury and the Bank of England formulate their separate advice to the Chancellor on interest rates. The Chancellor makes his decision in the light of that advice.

M. King~Journal ~[' Monetat T Economics 39 (1997) 8l 97 93

Publication of minutes. Since April 1994, the minutes of the Chancellor's monthly meetings with the Governor have been published. The minutes are published two weeks after the subsequent meeting has taken place, which usually means a delay of six weeks. The minutes make public the Bank's precise advice on interest rates month by month, and enable the public to check that the Governor's advice is consistent with the analysis published in Inflation Reports and assess the reasons for any disagreement between the Governor and Chan- cellor. Since the Spring of 1994 there have been several disagreements between the Chancellor and the Bank on the appropriate level of interest rates. These public disagreements are one of the costs to the Government of deviating from its inflation target.

Discretion over timin,q of rate changes. In November 1993, the Bank was given sole discretion over the timing of interest rate changes, with the understanding that any change decided by the Chancellor would be implemented before the next monthly meeting. That change was designed to allay suspicions that the timing of interest rate movements might be determined by calculations of short- run political advantage. In practice, once a decision on interest rates has been reached at the monthly meeting, any change has been implemented at the first possible opportunity. This practice has evolved over the past year or so, and the Bank has now stated publicly that it would only delay a change in rates if there was an overwhelming public reason for so doing.

What do these changes add up to? In the first LSE Bank of England Lecture, the then Governor, Lord Kingsdown, described the measures announced in the Chancellor's 1992 Mansion House speech - in particular the new Inflation Report

in these terms: "while they may appear to be a small step for Britain, they are a giant leap for the authorities" (Bank of England, 1993). The further changes made subsequently, and, in particular, the decision to publish the minutes of the monthly Chancellor-Governor meetings, certainly amount to an additional leap. The explicit policy advice tendered by the Bank to the Chancellor each month is now available to the public not after thirty years but after six weeks. To go from thirty years to six weeks is, by any standard, more than a small step.

Openness can improve credibility by helping private sector agents predict how the monetary authorities will react to developments in the economy. The lnltation Report has already improved public understanding of the Bank's thinking on inflation, and publication of the minutes of the monthly monetary meetings should, in time, increase the accuracy of market expectations of the authorities' 'reaction function'. Indeed, the commentaries of city and press scribblers have already shown an increased awareness of official thinking, based not on speculation about 'who said what?', but on an appreciation of the Government's and the Bank's analyses of the economy. As a result, over time the minutes should contain fewer surprises, thus contributing to the stability of macroeconomic policy.

94 M. King~Journal o/' Monetary Economics 39 (1997) 81-97

4. Implementation of state-contingent rules through an inflation target

The choice of monetary strategy is often described as a choice between rules and discretion. As showed in Section 2, neither in its pure form is optimal. The optimal strategy is a state-contingent 'rule', which allows flexibility in the response of policy to shocks while retaining a credible commitment to price stability. The real issue is how to find an incentive-compatible mechanism to support the optimal state-contingent rule. How are central bankers to be given incentives to behave in the optimal fashion?

McCallum (1995, 1996) has argued that independent central banks should, and would, 'just do it'. But that requires central bankers to have a very long time horizon. They may do so, but there is no guarantee that they will. Central bankers, despite their prudent and austere life-style, do not live for ever. They tend to be judged by the realised value of the loss function during their term of office, and rarely on whether the loss subsequent to their retirement was lower than it would otherwise have been. That raises the question of whether the preferences of central bankers are adequately captured by the loss function defined in Section 2.

If the loss function of central bankers is not defined over the same arguments as enter the loss function of Parliament or the public, then there is a standard principal-agent problem. Moreover, it is not simply a question of whether the parameter measuring inflation aversion (the parameter a in the above model) is higher for the central banker than for Parliament, but of the basic objectives of the central bank itself. In responding to an early draft of Fischer's (1990) paper on rules and discretion, Friedman wrote of the loss function of central bankers in the following terms: "From revealed preference, I suspect that by far and away the two most important variables in their loss function are avoiding accountability on the one hand and achieving public prestige on the other" (quoted by Fischer). One aim of the UK measures to enhance transparency and openness was to improve accountability, on the one hand, and to increase the public prestige associated with hitting the inflation target, on the other.

How does an inflation target provide the appropriate incentives for central bankers to follow the optimal policy reaction function? In particular, can it cure the inflation bias implied by the use of discretion? The most obvious way in which an inflation target can reduce inflation bias is by creating a cost to the monetary authorities of deviating from their pre-announced target. It is a criterion by which the authorities state that they wish to be judged. It is possible to go further and impose penalties on central banks that fail to achieve the target. In the case of New Zealand, it is possible that the Governor of the Reserve Bank might not be reappointed explicitly on the ground that he or she had failed to achieve the inflation target. To lose one's job in such circumstances would certainly be a failure 'to achieve public prestige'. The key, therefore, is to align the personal incentives facing central bankers with the objectives implied by the optimal policy reaction function.

M. Kiny/Journal of Monetary Economics 39 (1997) 81 97 95

Some authors have gone further, and argued that an inflation target can be seen as an optimal contract between the public and the central bank. That viewpoint has been argued most forcefully by Walsh (1995), and Persson and Tabellini (1993). As Walsh pointed out, and as was shown above, the inflation bias implied by discretion is independent of the magnitude of the supply shock. This suggests that there may be two ways in which the central bank can be persuaded to eliminate the inflation bias in a discretionary policy. The first is to impose upon the central bank a penalty equivalent to the magnitude of the inflation bias. That could be either a monetary penalty related to the out-turn for inflation, or a non- pecuniary penalty of loss of public prestige if inflation is above the target rate. But attempts to explain how such a penalty might work in practice tend to revert to reducing the public prestige of the central bank if the inflation out-turn is above the target rate, although it can be bolstered by fixing the salaries and budget of the central bank in nominal terms. The second method is to set an inflation target lower than the desired level by an amount exactly equal to the inflation bias. Svensson (1995) has suggested this use of an inflation target to eliminate the inflation bias. But, in my view, there is a problem with that approach. It implies that an inflation target is set which the central bank will, on average, miss. It is not clear how this fits in with the idea of a contractual relationship between the public and the central bank. Rather, it is an alternative version of a conservative central bank governor in which the definition of 'conservative' is that the governor's target inflation rate is below that of the public at large. In contrast, Rogoff (1985) defines 'conservative' in terms of the trade-off between the volatility of inflation and output. Under the alternative definition, if the public are committed to price stability the conservative central banker is someone whose target inflation rate is negative. Although it is possible to argue that the optimal inflation rate is indeed negative, in order to equate the marginal cost of production of money with the marginal benefit of holding cash, there are not many conservative central bankers in practice who profess that view today. Perhaps, the idea is more plausible in the context of a public which accepts low inflation but not full price stability, and a conservative central banker who is truly committed to price stability.

There remains, however, the difficulty that if the contrast is designed to overcome the time-inconsistency of government behaviour, the central bank will know that the contract is unlikely to be enforced by such a government. If an inflation target is to overcome that problem, it must ensure that failure to achieve the target leads to a reduction in the public prestige of the central bank and its senior officials. That argument fits in neatly with the view that the reason for delegating monetary policy to an independent central bank is precisely that its officials can be held accountable for the outcome of its policy decisions, and can be given an incentive structure directly related to its performance on inflation.

In practice, the main difficulty in relating the actual inflation out-turn to the policy implied by the optimal reaction function is the existence of shocks which mean that the optimal inflation rate will vary from period to period. In order

96 M. King~Journal of Monetary Economics 39 (1997) 81..97

for the inflation target to be a disciplining mechanism, the public must be able to use the target to monitor the performance of the central bank. The optimal policy reaction function generates a distribution of inflation out-turns, and the sample distribution may be used to compare performance with the desired outcome. Ex post monitoring should be in terms of the distribution of inflation and not just its average level. Of course, the first moment of the distribution is more important than the higher moments. And its value represents the extent to which the central bank has been able to avoid the inflation bias of discretion. But since it is important to improve on the performance of an 'inflation nutter', the optimal policy is characterised by a distribution of inflation and does not imply that inflation is equal to zero in each period. Hence, although the target range for inflation should, in the model presented above, have a mean of zero there is also an optimal target range. For example, if the target range is defined as covering the range within which inflation should fall two-thirds of the time, then, assuming the shocks to be normally distributed, the inflation target should be defined to be the range

[ -b / (a + b2), b/(a ~- b2)]. (17)

The requirement that the central bank explain openly and transparently not only its policy decisions, but also the analysis and forecasts upon which those policies are based, is an important component of monitoring. Not only does it help the private sector to understand the policy reaction function of the central bank, but it also helps both principal and agent when the latter explains to the former the nature of the shocks which have led the inflation outcome to be what it is. That is the aim of the Bank of England Inflation Report. When shocks lead inflation to diverge from the target, explanations will be credible only if they are based on a track record of openness and a coherent explanation of economic developments. Svensson (1996) has suggested that monitoring be based on inflation forecasts rather than actual out-turns.

Not all states of the world relevant to monetary policy can be imagined in advance. Hence no written contract between government and central bank could ever be complete. Some evaluation of performance will be necessary in the light of subsequent shocks. Transparency of the monetary policy process makes it easier to distinguish between those central banks who were wrong for the right reasons (failed to anticipate an unpredictable shock) and those who were simply wrong (weak or faulty analysis). It is important also for a central bank to be open about what neither it nor anyone else knows (the level of the natural rate of unemployment, for example).

In this way, a combination of an inflation target a high degree of openness can be thought of as an attempt to approximate the optimal state-contingent policy rules. The aim is to make the central bank accountable for its decisions and to provide it with the incentives to pursue the optimal rule. I f the sample distribution of inflation is to be used as a monitoring device, then it would be sensible to

M. King~Journal of" Moneta O, Economics 39 (I997) 81 97 97

give responsibility for monetary policy to an institution, rather than an individual, whose performance can be monitored over a long period.

5. Conclusions

It is too early to make strong claims for the inflation target approach to monetary policy pursued in the UK since the end of 1992. Inflation in that period has been lower than any decadal average in the post-war period. Moreover, both nominal and real demand have been more stable than in past expansions. But the test will be the persistence of low inflation over a long period of time. The combination of an explicit inflation target and institutional measures to promote the transparency of policy have led to a more open and informed debate about monetary policy in the UK. And all major political parties have said that they wish to retain the new arrangements. Some have gone further and proposed changes to give an even greater role to the Bank of England.

References

Fischer, S., 1990. Rules versus discretion in monetary policy. In Friedman, B.M., Hahn, F.H., (Eds.), Handbook in Monetary Economics, vol. ll. Elsevier Science Publishers Amsterdam.

King, M.A., 1994. Monetary policy in the UK. The Institute of Fiscal Studies Annual Lecture, 1994 (reprinted in Fiscal Studies) 15, 109 128.

King, M.A., 1996a. How should central banks reduce inflation? - conceptual issues. Federal Reserve Bank of Kansas City (1996). (Reprinted in the Bank of England Quarterly Bulletin 36, No. 4, Nov. 1996).

King, M.A., 1996b. Monetary stability: rhyme or reason? Seventh ESRC Annual Lecture, Economic and Social Research Council, London (reprinted in the Bank of England Quarterly Bulletin 37, No I, February 1997).

Kydland, F., Prescott, E., 1977. Rules rather than discretion: the inconsistency of optimal plans. Journal of Political Economy 85, 473-492.

McCallum, B.T., 1995. Two fallacies concerning central bank independence. American Economic Review Papers and Proceedings 85, 207-211.

McCallum, B.T., 1996. Crucial issues concerning central bank independence. National Bureau of Economic Research Working Paper 5597, Mimeo.

Persson. T., Tabellini, G., 1993. Designing institutions for monetary stability. Camcgie Rochester Conference Series on Public Policy 39, 53 84.

Rogofl', K., 1985. The optimal degree of commitment to an intermediate target. Quarterly Journal of Economics 100, 1169-1189.

Simons, H.C., 1936. Rules versus authorities in monetary policy. Journal of Political Economy 44, I 30.

Svensson, L.E.O., 1995. Optimal inflation targets, "conservative' central banks and linear inflation contracts. Mimeo, Institute for International Economics, University of Stockholm.

Svensson, L.E.O., 1996. Inflation forecast targeting: implementing and monitoring inflation targets. National Bureau of Economic Research Working Paper 5797, Mimeo.

Walsh, C., 1995. Optimal contracts for central bankers. American Economic Review 85. 150 -167.

changes in uk monetary policy: rules and discretion in practice

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