Having an independent Central Bank targeting inflation is the best institutional structure for a country to adopt.

 

Central Bank is one of the most important institutions of the developed countries. Presently each country has its own, although this could gradually change when European Union integration progresses.

 

Originally central bank was there to ensure that money got printed and delivered. The interventionist policies, like financing wars by printing money, came later. Nowadays it is widely thought that the Central Bank should intervene with the economy to increase the wellbeing of the public.

 

The most common objectives for the central bank have been the reducing of inflation, unemployment and the variability (or uncertainty) in the system, but also increasing economic growth and managing the external account. Traditionally the Central Banks were all nationalised (or owned by the King), at present more and more Central Banks are becoming independent. This essay tries to explain why the aims of the society are better served by an independent institution and what aims should it set as its priorities.

 

Why use inflation targets?

Some objectives of the society are better accomplished by fiscal intervention, some by supply side microeconomic policies and some by monetary policy. Monetary policy differs from the other in a way, because money is thought to be mostly neutral in the long run. Thus the monetary policy should be used for more immediate, day-to-day adjustment.

There exists some trade-off between the instruments of monetary policy, interest rates and money supply, and inflation. There is also a trade-off between inflation and economic growth in the short-run. These are the factors that the monetary policy can change. Thus the monetary policy is not suitable for accelerating growth in GDP or reducing unemployment permanently.

The things that matter in the short-run are inflation and volatility, because both of them are path dependent -, once they increase they increase permanently (inflationary spirals and ARCH models of the economy are prime examples). Thus the monetary policy nowadays deals with mainly stabilising fluctuations and keeping inflation low. What follows is a discussion of the relative importance of these two goals and then reasons why inflation targeting is more suitable than targeting interest rates, money supply or nothing at all. I will leave the discussion of fixed rules of monetary policy until I have discussed the theoretical arguments in conjunction with the Central Bank independence argument. Furthermore I will completely leave off the discussion about international currency flows, exchange rates etc.

 

Taylor has produced what is now known as the production possibility frontier for inflation and GDP variance. It looks like any normal PPF, so it will not be repeated here. The key message is that there is a trade-off between reducing the variability of inflation and the variability of GDP growth. If the Central Bank is efficient then the total amount of the increase in variability is fairly constant. What Taylor has shown is that although it seems like one has a choice between inflation variance and GDP growth variance based on the preferences of the society, in general the marginal costs associated with inflation variance greater than GPD variance and vice versa are very large. Thus, except for some bizarre extreme preferences, the society should always chose to equate the variance in GDP growth and the variance in inflation.

 

Second point emerging from this discussion is that targeting the variance is only relevant after the shocks, so it does not suit very well for formal everyday targeting - most of the time the variance is unchanged and the Central Bank would have very little to do. Similarly, the goal of smoothing out trade cycles is not good. Normally the uncertainty reduction arising from smaller variance is enough, reason being that the economic models are generally not considered adequate yet for the fine tuning of the economy.

 

On the other hand, inflation can change on a day to day basis with the progress of the trade cycle and the change in the expected interest rates. Furthermore, it is important that the inflation remains in a predictable range because the real interest rates and thus investment costs directly depend on it. Thus it is important for the Central Bank to control the inflation continuously, and make forecasts in it, especially because the lags in the instruments take time to work itself through and thus one needs an elaborate forecasting mechanism.

The most suitable target is not 0% growth in GDP, because the CPI overestimates true inflation. It is also debatable whether true inflation should be 0 – one must weight the arguments of increased labour market flexibility with intergenerational loss, increased difficulties in operating and planning ones savings.

 

When one has established that the control of the inflation is indeed the primary goal of the Central Bank then the next step is to arrive at the best possible instrument. Money supply targeting was suggested by Milton Friedman in 1980-s, however it is not sufficient anymore, because the money does not have stable velocity at the moment and the growth in money is not very closely correlated with inflation.

 

Setting short-term interest rates either to keep the nominal or real interest constant have also been suggested. However, these options are too short term, a better and more effective policy is to target inflation directly by adjusting the rates so as to keep the inflation constant. However, the constant interest rate policy should be preferred if the society intensely dislikes unemployment and does not care much about inflation, as the unemployment will be generally smaller and less variable under fixed exchange rate. Using the inflation target seems just hard enough target for the MPC, they are managing to keep it where needed, but not too easily, by adjusting the overnight repo rate.

 

Setting the policy according to the market expectations has also been suggested. However, this is not the best option because trading in market causes excessive volatility. Taylor showed a prime example with the implied forward rates 29 years ahead and the interest rates now being correlated with R² of over 0.5 implying that the markets are not rational in making their decision. Cox and Ross have shown that this is due to the equilibrium models and no arbitrage models differing in the short-run. Basically when there is irrationality in some part of the system, this must be transmitted to the other parts for all the arbitrage opportunities to disappear.

 

Targeting the inflation has another advantage – one can experiment with reducing unemployment and observe when inflation starts to rise to figure out the minimum sustainable unemployment. This result arises from the empirical result that the Philips curve is linear in short run meaning that unemployment below NAIRU will not carry exponentially increasing costs.

 

Why independent Central Bank is better

We mean by the independent bank the independence in operational terms only. The target for the policy is set politically, the Bank will choose the best means to achieve that target.

One can argue that the amount of information available to base the decisions concerning the operations of the Bank is too large to be analysed rationally and exhaustively. It is different with policy, because the number of simple policy targets is limited. However, the number of instruments and the combinations of how to use them is virtually unlimited. It can be argued that independent Bank is more flexible in adopting the new information and thus can act faster. Hayek sayd that independence produces spontaneous order and this will be more effective than planned order when the organisational unit gets bigger than a firm or a family. Although he uses the collapse of the Soviet Union as an example, I think it is equally applicable to the Central Bank.

Kydland and Prescott in 1970s and later on Barro produced one further argument why the efficient markets will have externalities in the state owned Central Bank - a dynamic inconsistency of low inflation monetary policy will arise. This argument is in all standard textbooks, so I will not reproduce it here. Its conclusion is that politically controlled Central Bank will be forced to push up inflation in the short-term to get the political benefits of low unemployment. This leads to now gain in employment in the short run, but higher inflation, and there is some impressive data to support that.

 

Why is it then that although in completely efficient markets independent Bank is preferable, many people still support the government owned banks?

The main reasons probably are historical and arise due to risk aversion. In spontaneous order, nobody can predict what the exact outcome will be and that will make the public reluctant to go for it. Also historically the Central Bank has been owned by the state, again due to risk aversion and transaction costs, politicians are unwilling to change that.

However, there are also some political considerations. Firstly the argument of dynamic inconsistency is not supported by empirical findings. Inflation was falling in 1980s without any increase in independence and there are some other similar facts. If it becomes apparent to the public that unemployment gains from higher inflation are temporary (and assuming that individuals are rational, they will be able to figure that out instantaneously) then the politicians will automatically set proper targets for unemployment. Otherwise rational people will realise that the bank is cheating. Furthermore, the Bank can also build reputation for being conservative and disliking inflation.

Rogoff also shows that independent Central bank will be too conservative and this will lead to too large volatility in output as only shocks in inflation is taken into account. Assuming the welfare loss function is quadratic in both inflation and GDP, this will lead to a loss in welfare.

However, Summers shows it is not so empirically, possibly because volatility arising from changes in policy (which is eliminated by independence) is bigger than economical volatility. Also, Taylor has shown that the PPF for possible volatilities is so square-shaped, that the same point will be chosen for practically all indifference curves.

 

Furthermore, when the policy effects are uncertain it is better to be conservative in actions. There is a result that in order to maximise the welfare when the variance of possible outcomes is p, then instead of eliminating the bias by choosing policy g, the Bank should choose (g-p²/2).

 

Thus it is better for the Central Bank to be independent. It should give it an incentive to be more open, to look for better ways to explain the data (like use several time periods forecasts). However, it also gives it an incentive to cheat and pursue the personal aims of the directors of the Bank (the public choice theory), that is why an effective control system needs to be in place.

 

Finally, shouldn’t we have rule based Central Bank altogether with rules being determined by the Independent Bank and then followed. This would eliminate the discussion of independence and choosing right targets, once the rule is in place. Many commentators argue against the rules, because they think that the whole point of MPC is to avoid rules. They say that as long as the MPC is transparent in its decisions there is no need for rules.

However, the reality is that the MPC is not transparent. And rules would be an easy way to force transparency. However, these rules must be set very flexible. When the rule is changed every third meeting, it would still eliminate 2/3rds of the uncertainty about MPC decisions, so it would reduce the uncertainty in the financial markets. Looking at the simple Taylor rules – rise interest rates by 0.5% when either GDP growth or inflation is more than 1% of the mark shows that the rule outcomes closely mimic the actual decisions by MPC. Thus one would not sacrifice much flexibility by adopting such a rule and revising it very often.

 

Conclusion

There are two improvements that can be made to the efficiently operating capital markets. First, the volatility, which the only thing one can estimate in efficient markets (the estimation usually is by ARCH model that the volatility will remain the same) can be reduced by institutional actions. Secondly, for the irrational bunch that invest too much in speculative bubbles (they are probably rational in optimising the amount of information they gather) the speculative bubbles can be popped as soon as they appear. It is not clear immediately from these two purposes why the independent Bank is better and why it should use inflation targeting. That is why there is so much discussion going on about these two issues.

However, at the end of the day one can always test the reasonable alternatives by looking at international cross-sectional data. Although there is only five years of data available for the Banks pursuing inflation targets, and this data period has fallen into an era of generally falling inflation, still it is the census conclusion today that Independent Banks provide better results. The preceding analysis only applies to well-developed countries. The evidence for the developing countries suggests that due to much political instability, unreliability of data and corruption the best system should be as much rule-based as possible. Like the currency board system adopted by many developing Eastern European countries at present.