Comparative Central Banking and the Politics of Monetary Policy: The Relationship Between Governments and Central Banks Must be Balanced and Defined

Business Economics, Oct, 2001 by Laurence Meyer

All central banks must steer a careful course between independence and accountability. There are four important mechanisms: legislative mandate, instrument independence, informal interactions with government, and government procedures to foster accountability. Inherent conflict between independence and accountability makes balance a crucial component of successful central banking. If this balance is not struck successfully and there is not a shared understanding of the roles of government and the central bank, it is unlikely that stabilization policy will be successful. Transparency is also important for credibility and accountability.

I have a very specific topic: how the Fed balances independence and accountability. The answer is quite simple: carefully. I'll have something more to say about this balancing act, but first I would like to address a broader set of questions, especially in the context of international perspectives on the process of monetary policy formulation. I would like to pose a question--actually a set of three interrelated questions about comparative central banking. First, how similar or different is the practice of monetary policy across the central banks represented on the panel? Second, if practices are different, what accounts for the differences? And, third, what are the consequences of these differences for macro-economic performance?

Monetary policies may, of course, appear different because the circumstances faced by central banks differ around the world. That would especially be the case if there were important country-specific shocks. But it could also be the case if common shocks affected countries differently because of differences in the structure of the economies or even if initial conditions differed at the time they were hit by a common shock.

An even more interesting question--and a better lead-in to my assigned topic is: To what extent do different central banks respond differently to the same set of circumstances? Here's a wonderful game: Assume that the European Central Bank (ECB) governing council or the Bank of England's Monetary Policy Committee replaced the Federal Open Market Committee (FOMC) and made monetary policy in the United States--or vice versa. How would policy outcomes and, in turn, macroeconomic performance be affected?

Comparative Central Banking

Why would central banks differ in their response to a given set of economic circumstances? Let me offer a few possibilities. First, the central banks could have different objectives. How similar, for example, is the U.S. dual mandate--full employment and price stability--to the singular or, more precisely, hierarchical mandates for the ECB and the Bank of England? Under hierarchical mandates, price stability or low inflation is typically the principal objective, and other objectives can be pursued only once the inflation objective is met.

Second, there could be different strategies for achieving a given set of objectives. Of course, the most important factor in determining monetary policy strategy is likely to be the nature of the objectives themselves, so any differences in strategy may be related to the first question. At any rate, is a Taylor-rule type of approach--well aligned with a dual mandate and therefore a simple representation of the U.S. policy response-different in practice from the flexible inflation-targeting strategy of the Bank of England and the two-pillar strategy of the ECB? If so, what are the consequences of the differences in strategy for how central banks respond to unexpected developments?

Third, what determines how effective a central bank is in meeting its objectives, given its strategy? This takes us into the main subjects that this program will cover. To what extent does the process followed in making monetary policy shape the details and effectiveness of the outcomes? Does the nature of the governance and decision process matter? For example, does it matter whether there is a single governor or a committee; whether there are outsiders as well as insiders on the committee; whether there is individual or collective responsibility for the decisions of the committee; and whether the committee is made up only of centralized members or also includes regional representatives? Does the effectiveness of policy depend on the central bank's skill in communicating the intent behind its policy and the future direction of policy and, therefore, on the transparency of the process itself? Does the effectiveness of the policy depend on the instrument independence of the central banks as well as the overall relationship between the central bank and the rest of government?

It is interesting to try to identify differences in practice among central banks. But is the more meaningful story a convergence in practice around the world? Is there any real difference between a monetary policy executed under dual mandate and under flexible inflation targeting? If central bank practices are converging, is this due to a convergence in the economic environments or to greater acceptance of a common intellectual framework regarding what central banks can and should do, as well as how those goals can be achieved?