By C.A.E. Goodhart
Financial Markets Group
London School of Economics
(Following are the excerpts from the independence memorial lecture delivered at the Centre for Banking Studies at Rajagiriya.)

The Rationale for an Independent Central Bank

One of the big ideas in the economic arena in the last two decades has been that the operation of monetary policy, by which I mean command over the decision to alter interest rates, should be delegated to an independent central bank. I want to start this lecture by considering why and how this came about, the nature of the resulting interaction with fiscal policy, and then the short-run trade-off between the deviations of output and inflation from their respective targets. Then I want to conclude by discussing some of the additional problems that developing countries, such as Sri Lanka, might face in adopting such a regime. This discussion may have some relevance to your own current proceedings regarding widespread reforms in the financial sector.

I understand that this country has faced some parallel problems here last year by creating several commissions independent of the legislative and executive branches of government. This process has been further strengthened in the amendments to the Monetary Law Act in 2002, whereby the appointment of the Monetary Board by the President of the Republic is subject to approval by the Constitutional Council, a body itself independent of government.

The second strand of argument relates to the danger that an executive, and the legislature, having together established the underlying laws and regulations by which a country should be run, might then be tempted to bend or to subvert the subsequent legal and operational rulings in their own short-run political interest. This danger is all the greater because the executive, especially when it dominates the legislature, as it is designed so to do here in the UK, has great power. It is this concern that leads to the separation of the judiciary, the least dangerous of the three main arms of government, from the executive and legislature, so that the interpretation and enforcement of the rules of law are carried out through an independent judiciary, though here, as elsewhere, accountability and transparency are essential to maintain democratic legitimacy. The people have a right to know the legal grounds on which a case has been settled.

Within the field of monetary policy, the potential subversion of the underlying objective of price stability goes under the jargon terminology of ‘time inconsistency’, which harks back to the famous Kydland/Prescott paper. That demonstrated how long-term commitments would often be foregone in pursuit of short-term (electoral) expediency. Much of that literature, following certain strands of American thought, exaggerates political venality, suggesting for example that politicians consciously try to fool the public by covertly expanding monetary growth prior to elections. Considering that the monetary policy instrument involves setting interest rates, which is a highly visible process, and that the effects of this on the economy require long and variable lags, the implausibility of instigating a covert political business cycle via monetary manipulations is clear. The same holds true, more or less, when the policy instrument is some form of direct quantitative control of the monetary base, or some other monetary aggregate, the data for which are usually rapidly available.

Nevertheless there are milder forms of time inconsistency. Because of those very same lags, interest rate increases now need to be made to counter forecast inflation threats in the future, say 18 to 24 months hence. But forecasts of the likely onset of inflation at such a future date are inherently uncertain, and increases in interest rates, which thereby also tend to depress asset prices, are widely unpopular. Hence politicians are loathe to raise interest rates just on the basis of forecasts, but would rather wait until there is clear and present evidence of rising inflation. But by then it is too late to nip the inflationary pressure in the bud.

The key result of this line of analysis is that a central bank should have a single, measurable and quantifiable, primary policy objective, to wit the rate of inflation. Hence accountability and visibility are enhanced. There are no trade-offs; no discretionary judgements between competing objectives. Moreover, when the government is involved in establishing the objective, by defining the proposed path for the inflation target, there is no democratic deficit either. Indeed, the public accountability of monetary policy has been greater in my own country since 1997, when the incoming Labour government changed the regime, than in any previous period.

In this respect, I must confess to having some concerns about both the width and the somewhat fuzzy nature of the objectives for the Central Bank that have been set out in the Monetary Law Amendment Bill presented here last Autumn, though I welcome the additional degree of independence granted to your Monetary Board. These objectives include economic as well as price stability, and furthermore price stability.

As I shall later discuss, you cannot simultaneously commit to stabilising the domestic price level and the exchange rate simultaneously. There is a trade-off. Not committing to one, or the other, leaves a degree of fuzziness which limits both transparency and accountability.

Similarly, and even more important, over the medium term all that a central bank using nominal monetary policy instruments can control are nominal magnitudes, for example price inflation and monetary growth. It is inappropriate to try to make a central bank responsible for underlying real economic stability. It does not have the instruments or power to do that. Asking a central bank to achieve economic stability also tends to shift commentators’ gaze from those other bodies in the government that should be responsible for real developments. The best support that a central bank can give for economic growth is to provide a background of price stability, against which economic decisions can be made more sensibly.

The Inter-Relationship between Monetary and Fiscal Policies

Yet, while many democratic societies have independent central banks, every one leaves tax policy in the hands of elected politicians. In fact, no one even talks about turning over tax policy to an independent agency. Why? I leave this question as food for thought, perhaps for another day."

My own answer to this conundrum is that, unlike monetary policy which has one single overriding objective, ie. price stability, fiscal policy is intrinsically concerned with at least three objectives, these being allocative efficiency, income distribution and macro-economic stabilisation and adjustment. I would contend that any fiscal package will tend to affect each of these in different ways, so trade-offs are almost inevitable, and the resolution of such trade-offs would seem to require a political decision-making process.

There have, however, been occasional attempts to reduce the dimension of such political horse trading in the fiscal arena by seeking to separate decisions on the overall macro-economic magnitudes, ie. to force a decision on the aggregate size of the fiscal deficit, separate from subsequent, second-round decisions on the individual elements of the budget. The bill before your parliament entitled Fiscal Management (Responsibility) Act provides that the budget deficit at the end of the year 2006 shall not exceed five per centum of the estimated gross domestic produce and ....that such levels (shall) be maintained thereafter’. This kind of constraint is particularly common, and indeed necessary, when several states with independent fiscal powers share a single, federal monetary system. Otherwise spill-overs from the individual states’ fiscal decisions onto the common monetary system could all to easily lead to an untenable tension between the fiscal policies of the separate states and the single federal monetary policy, and, in particular, to concern whether a federal government might be induced to bail out a bankrupt subsidiary state.

This does raise the question of whether, besides the appropriate limitation on subsidiary state budgets, there should be independent decisions, or outside constraints, on the aggregate budget deficit either of unitary, or of federal, countries. There are many considerations. For example, the macro-economic effect of a given overall deficit is not independent of the composition of its component items. Again, how should one respond to the working of the automatic stabilisers in influencing the deficit?

The Additional Problems of Developing Countries

Let me turn now to the additional problems that developing countries face when trying to implement an inflation target regime. As we have seen, the major problems of short-run tradeoffs arise when there are supply shocks. Such supply shocks are particularly evident in primary production, especially in agriculture. Agriculture, and primary production more generally, plays a larger role both in output, and with the consumption of food being a major element in price indices, than in more developed countries. Agriculture is subject to the vagaries of changing weather patterns, as you found here in 2001.

Although bad harvests can play havoc both with output and inflation in the short run, I do not think that this derails the case for inflation targets. It does, however, have several implications. First, the width of the acceptable range, or band, should be somewhat greater. Second, there needs to be even more emphasis on the medium term, 2 or 3 year, horizon for the target. Third, when the inflation target is temporarily missed because of supply side adverse shocks, there needs to be a clear, and publicly exposed, plan for regaining the target path.

Another concern is whether the nature of the transmission mechanism of monetary policy differs between developing and developed countries. Yes, it differs, but it is not necessarily much weaker than in developed countries. Within developed countries, the mechanism depends on changes in interest rates, working through a wide variety of financial intermediaries and financial markets to affect a wide range of expenditures, both by persons and companies. In particular personal expenditures on housing and big ticket consumer items is an important element in the transmission mechanism in my own country.

Within developing countries, financial markets are less developed, and the allocation of funds via banks is often more influenced by quantitative constraints than by pricing through interest rates. While this latter feature has adverse effects on efficiency and growth, it does not hinder a central bank’s ability to control nominal incomes and prices. A central bank in a developing country can, and should, keep a close watch over the rates of growth of the monetary, and credit, aggregates.

Within developed countries, central banks can, and do, vary their interest rates directly to aim to hit the inflation target, so that the time path of the monetary aggregates is to them a somewhat residual issue, more of a memorandum or information variable. Within developing countries where access to credit is more limited, much more immediate and direct concern does need to be directed to the rates of growth of such aggregates, as well as to assessing the appropriate level of interest rates.

Now so -far I have mostly emphasized the transmission effect of monetary policy onto domestic expenditures, putting onto one side the effect(s) on exchange rates, and hence on imports and exports. But in a small open economy, like Sri Lanka, it is very largely through such external effects that monetary policy has both its quickest and its strongest impact. Unfortunately the monetary management of an open economy is far from straightforward.
(To be continued)