Laurence H Meyer: Comparative central banking and the politics of monetary
policy
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, at the National Association for Business Economics Seminar on Monetary Policy and the
Markets, Washington, DC, 21 May 2001.
* * *
Diane gave me a very specific topic: How the Fed balances independence and accountability. The
answer, of course, is quite simple: Carefully. I'll have something more to say about this balancing act
in a moment, but before I do I thought it would be fun to start out with a broader set of questions,
especially given the exciting panel that is going to follow lunch. That panel includes monetary policy
committee members from the European Central Bank, the Bank of England, Canada, and the United
States. Very nice job, Diane.
So, I would like to get today's program going by posing a question to the first panel, 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 macroeconomic 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 ECB governing council or the Bank of England's Monetary Policy Committee
replaced the Federal Open Market Committee 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 - some of which I hope will be explored by the next panel.
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 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?
The politics of monetary policy
Well I have finally reached my assigned topic - the politics of monetary policy. I use the term to
describe the relationship between the central bank and the rest of government. In an earlier paper on
this subject, I emphasized the way this relationship balances independence and accountability. But the
relationship between the central bank and the rest of government typically has four dimensions.
First, the legislature will usually limit central-bank independence by imposing a mandate - a specific
set of responsibilities or objectives.
Second, the legislature will often ensure instrument independence for the central bank, thus insulating
monetary policy from the short-term political pressures related to the electoral cycle. The mandate and
instrument independence usually reflect formal institutional arrangements, typically set by statute (or,
in the case of the ECB, by international treaty).
Third, the central bank will typically engage the legislative and executive branches in a variety of
informal interactions. Such informal relationships may play a particularly important role in facilitating
the coordination of monetary and fiscal policies and, in the case of the legislature, also allow for
appropriate oversight.
Fourth, the legislature typically establishes procedures to hold the central bank accountable for its
policy decisions. As I noted in my earlier paper, instrument independence can appear inconsistent with
democratic ideals. Therefore, there is generally an attempt to balance independence and
accountability. This provides incentives for good performance and maintains the connection between
the monetary policy process and publicly elected government officials.
It is important to appreciate that steps to encourage accountability typically offer opportunities for
political pressure. The history of the Federal Reserve's relationship with the rest of government is
marked by efforts by the rest of government both to foster central-bank independence and to exert
political pressure on monetary policy.
The mandate
Let me comment briefly on each of these relationships. The mandate is, of course, central to the
conduct of policy, or, at least, it should be.
The Fed's dual mandate - full employment and price stability - is really quite unique. Actually, the
specific language of the mandate is that the Fed should promote price stability and maximum
employment. We presume that the Congress did not intend to give us contradictory objectives, so we
interpret the objectives as price stability and maximum sustainable employment. Maximum sustainable
employment is also sometimes referred to as full employment, the maximum level of employment
sustainable without upward pressure on inflation.
The key to the dual mandate is that the two objectives are sought at the same time, though the relative
weights are left to the discretion of the central bank. Canada, Great Britain, and the ECB, on the other
hand, all have hierarchical mandates that single out price stability as the principal objective and allow
the central bank to pursue other objectives only after the price stability objective has been achieved.
Central banks operating under hierarchical mandates typically set their inflation objective in terms of a
forecast or as a medium-term objective, allowing a gradual return to their objective if inflation deviates
from it. In addition, the different regimes appear to have converged over time. It is harder to tell the
difference between what Lars Svensson refers to as flexible-inflation-targeting and dual-mandate
regimes. So the question with respect to the mandate remains: Does it affect the policy outcomes and
macroeconomic performance among the countries represented on the first panel?
Assuming there is no long-run trade-off between inflation and unemployment and assuming that the
economy gravitates to full employment in the long run, central banks will achieve full employment and
price stability in the long run under either mandate. But the nature of the mandate could affect their
choice of where their policies might put them on the trade-off between output variability and inflation
variability. Does the dual mandate make the Fed more responsive to downward demand shocks?
Does the hierarchical mandate permit Canada, Great Britain and the euro area to more tightly control
inflation over the shorter run? Or do practices among these central banks differ less than it might
appear from a strict reading of their mandates? By the way, I only have time to ask the interesting
questions, not to answer them. That will be the panel's job, I hope.
Instrument independence
Each of the central banks represented on the panel has instrument independence. The motivation for
granting such independence is to insulate the central bank from political interference, especially
interference motivated by the pressure of elections to deliver short-term gains irrespective of
longerterm costs. The purpose of this insulation is not to allow the central bank to pursue whatever policy it
prefers - indeed, as I just noted, governments invariably define the broad goals for the central
bank - but instead to provide a credible commitment of the government, through its central bank, to
achieve those goals, especially price stability.
Central bank independence is in part the result of formal institutional arrangements typically
incorporated in the legislation defining and creating the central bank. The most important requirement
is that the central bank is the final authority on monetary policy decisions. That is, monetary policy
decisions should not be subject to the veto of the executive or legislative branches of government.
This is further protected if other institutions of the government - typically the Treasury Department or
the Ministry of Finance - are not represented on the monetary policy committee. A lesser protection
would be to allow such representation, but only in a non-voting capacity, as is the practice at the Bank
of England and the Bank of Japan.
Instrument independence is facilitated by long overlapping membership terms, by limited opportunities
for reappointment, and by protecting committee members from removal, except for cause - where
cause refers to fraud or other personal misconduct but explicitly excludes differences in judgment
about policy. An intangible contributor to independence is the appointment of a capable, respected,
politically astute and "independent minded" chairman. Countries have many of the same protections of
instrument independence. An interesting question, however, is whether the differences in institutional
arrangements across central banks materially affect the degree of instrument independence in
practice. Do the shorter terms for members of the Bank of England's Monetary Policy Committee
affect their degree of independence relative to the longer terms for Fed governors? Does the presence
of non-voting representatives of the executive branch on the committees in Britain and Japan lessen
their effective degrees of independence compared to the United States?
Relationships in practice can be different from what they are in principle, so the independence of the
central bank depends on the evolution of informal as well as formal relationships between the central
bank and the rest of government. The history of the Federal Reserve is replete with examples of
attempts by presidents and senior administration officials to influence the conduct of monetary policy,
especially in periods leading up to elections. Sometimes this takes the form of
appointments - including specific instructions to appointees to vote in a particular way. Sometimes it
takes the form of pressure on the chairman and occasionally on other members of the FOMC.
The Fed has - throughout this process - built a reputation for independent policymaking and has had
the benefit of strong chairmen to sustain this direction. But independence is not something that should
be taken for granted. Rather, it is a work in progress that, now and again, will have to be defended and
protected.
Informal interactions and policy coordination
One potential tension is between independence and policy coordination. There is a fascinating and
quite famous, or infamous, episode involving the FOMC and the President in 1965. President Johnson
did not want the Administration's stimulative fiscal policy to be undermined by restrictive monetary
policy. Chairman Martin, on the other hand, supported an increase in the discount rate as an
appropriate step to contain the risk of higher inflation. A key vote on a proposed increase in the
discount rate occurred at a Board meeting on December 3. Not only did the President try to influence
the Chairman's position, but others in the Administration put pressure on other members of the Board.
The Board voted 4-3 to support the Chairman. Following the vote the President summoned the
Chairman to the President's ranch in Texas. But the vote stood. The independence of the Fed was
preserved and indeed used precisely for the purpose it was intended. It is now widely held that raising
the discount rate was the correct decision.
The minutes of that Board meeting make interesting reading. The debate was not just about the
importance of asserting the independence of the Fed. It was also about the importance of facilitating
policy coordination. Some members of the Board were reluctant to go counter to the policy direction of
the Administration, and preferred negotiation, given that the Administration also deserved a voice in
stabilization policy.
The coordination of monetary and fiscal policies has not been much of an issue since at least the early
1980s. At that time, fiscal policy shifted focus to longer-run issues - such as balancing the budget, or
setting a tax policy that supports economic efficiency and long-term growth. This left stabilization
policy virtually exclusively to the Federal Reserve. History reveals that this division of labor did not
eliminate tensions over monetary policy decisions. On many occasions, an Administration voiced its
displeasure - publicly or privately - with monetary policy actions. These communications were, as you
would expect, biased - they were all in response to decisions to raise interest rates and most often
occurred when those increases came shortly before an election.
The change in views about the role of tax-rate and spending adjustments as part of an activist
stabilization policy significantly diminished any need for ongoing coordination between monetary and
fiscal policies. The main issues of coordination in recent years have been about how monetary policy
should adapt to significant shifts in the direction of fiscal policy, which are motivated in turn by the
longer-run considerations. Recent examples include the monetary policy responses to the Clinton
Administration's deficit reduction direction and, going forward, to the Bush Administration's longer-run
fiscal program. I have described this kind of coordination as sequential decisionmaking. Fiscal policy is
slower moving. Once fiscal policy is decided upon, the Federal Reserve takes that policy into account
(and/or takes into account its expectations of future fiscal policies) when it sets monetary policy.
However, if fiscal policy wanted to play a more important role in active stabilization policy, the potential
for tension between the administration and the Congress and the Federal Reserve could increase,
especially at times when the fiscal and monetary authorities have different views about the cyclical
situation or if they have different objectives.
The relationship between the Federal Reserve and the executive branch was exceptional during the
Clinton Administration. Early indications point to a continued excellent relationship with the new
Administration. In contrast, the recent relationship between the Bank of Japan and the rest of the
Japanese government seems not to have been so good. This undoubtedly reflects in part the fact that
the Bank of Japan and the Ministry of Finance are still working out their respective roles following the
Bank gaining greater independence. An interesting question, however, is whether the tensions have
affected policy outcomes and macroeconomic performance. It sometimes appears that the result has
been a stalemate or the outcome of a noncooperative game.
For example, has the Bank of Japan been reluctant to engage in bolder monetization strategy in part
because of differences in policy priorities and tensions with the Ministry of Finance? The Bank of
Japan seems to believe that operations in longer-term government bonds reduce the incentive of the
government to move toward fiscal consolidation. Therefore, monetary policy in Japan might be
affected not only by views about how such policies would affect macroeconomic performance, for
given fiscal policies, but also by views about how fiscal policy might adjust to monetary policy. Another
way to pursue more stimulative policy, even once the nominal policy rate is driven to zero, might be to
carry out open market operations in foreign bonds - in effect, unsterilized foreign exchange
intervention. But foreign exchange intervention is at the discretion of the Ministry of Finance, not the
Bank of Japan, so this direction might at least give the appearance of ceding control of the timing and
magnitude of monetary policy actions to the Ministry of Finance. Such an appearance would be a
problem even under the best of relationships, but such a direction may be still less likely when there
are tensions between the two parties and when the independence of the central bank is so recent.
Finally, the Bank of Japan may believe that there are limits to what monetary policy alone can
accomplish and, given the uncertainty about the effects of monetization, may resist moving in this
direction until the government moves decisively to deal with banking problems and the overhang of
corporate debt and more boldly to open markets to domestic and international competition.
Coordination of monetary and fiscal policy in Europe has become much more complex, of course,
because the ECB formulates a unified monetary policy, while fiscal policy still is largely determined at
the national level.
Procedures related to accountability and transparency
Accountability is facilitated by providing the central bank with a specific, external (usually legislatively
imposed) mandate. Two aspects of designing the objectives for monetary policy are important. First, a
single objective (typically price stability) - or even a hierarchical mandate - makes the central bank
more accountable, because multiple objectives always carry trade-offs, at least in the short run, that
are subject to discretion by the central bank. Second, explicit numerical targets make a central bank
more accountable than more general targets. Specifically, an explicit numerical inflation target makes
central banks more accountable than a more general commitment to price stability.
The assignment of a well-articulated and tight mandate seems to be importantly related to instrument
independence. The well-articulated mandate for the Federal Reserve is a surprisingly recent
development; it became part of the Federal Reserve Act only in 1977. In this case, the timing of the
mandate did not correspond to any change in the degree of independence of the Fed. But, many
recent examples exist of central banks being given tighter mandates at the same time they were given
formal instrument independence. The tight mandate leaves the most important decision - that of the
goals of policy - in the political process, and it also facilitates the accountability of the newly
independent central bank. This was the case for both the Bank of England and the Bank of Japan.
Another consideration in the setting of the mandate is a trade-off between accountability and flexibility.
Flexibility can be a valuable asset for policymakers, given the variety of shocks that the economy may
face, the structural changes that could affect the nature of trade-offs confronting policymakers, and the
possibility of trade-offs among multiple targets. Less precise targets and multiple objectives provide
such flexibility for the policymaker. The Federal Reserve, with both a dual mandate and a less precise
inflation target, therefore appears to have greater flexibility compared to central banks that operate
under singular or hierarchical mandates and have explicit, numerical inflation objectives. Does this
matter in practice?
There appears to have been some evolution in inflation-targeting regimes toward greater flexibility. It
could be that the effort to sharpen accountability through a very tight mandate was viewed as most
important immediately after the granting of instrument independence. Such tight mandates might also
have been especially important at this juncture, which typically followed a period of poor inflation
performance and, hence, diminished credibility with respect to price stability. The tendency may be
natural to allow more flexibility when central banks are focused on inflation maintenance than when
they seek inflation reduction. More recently, inflation performance has been generally very good and
inflation-targeting regimes over time appear to have become somewhat more flexible. Indeed,
Svensson has characterized many central banks as now operating under "flexible" inflation-targeting
regimes, where the flexibility allows them in practice to take account of smoothing output relative to full
employment, perhaps making such regimes observationally equivalent to those operating under an
explicitly dual mandate. Is this true? In addition, central banks can also increase their flexibility in an
inflation-targeting regime by setting their objective in relation to an inflation forecast, rather than
current inflation performance, or by focusing on core, as opposed to headline, inflation - directions in
which inflation-targeting regimes appear to have evolved over time.
Once we allow for multiple targets and imprecisely defined objectives, the distinction between goal
and instrument independence may become blurred. Multiple targets that give central banks discretion
over the relative weights to be assigned to the objectives - and hence, with respect to short-run
tradeoffs, between the targets - in effect give the central bank some important discretion over objectives.
Similarly, the flexibility afforded by imprecisely defined targets also leaves some discretion about goals
with the central bank.
A second source of accountability is through the reappointment of committee members. If terms are
short and, especially if the chairman and the other voting members can be reappointed for additional
terms, more control can be exercised through the reappointment process, and committee members
can more easily be held accountable for their policy votes. This is another clear example of the
tradeoff between independence (facilitated by long terms without the possibility of reappointment) and
accountability (facilitated by short terms with opportunities for reappointment).
A third source of accountability is oversight hearings on monetary policy held by legislative
committees. In the United States, we have semiannual congressional monetary policy
hearings - formerly known as the Humphrey-Hawkins testimony. While many focus on the relationship
between the central bank and the executive branch, central banks are typically creatures of
legislatures who, in turn, control the degree of the bank's independence. The ECB again is unique as
a creature of an international treaty and its independence cannot therefore be eroded except by
unanimous agreement of the signatories to that treaty. The ECB participates in oversight hearings by
the European Parliament, but that body has no authority over the Bank. This makes the ECB, without
question, the central bank with the greatest degree of instrument independence and the least degree
of political accountability.
Transparency and disclosure are also essential to accountability. The legislature, for example, needs
information about the policy actions and an accounting of the rationale for the policy if it is to hold the
central bank accountable. In addition, it is generally agreed that markets work better with more
complete information, though some worry that a continuous flow of information about the leanings of
members of the policy committee can result in excessive volatility in financial markets.
Transparency can also contribute to policy effectiveness as well as to accountability. Monetary policy
works not only by setting the policy rate, but by conveying expectations to the markets about the future
course of monetary policy. This may be done intentionally or unintentionally, but markets will make
their own attempt to assess the future direction of policy and will try to glean whatever they can from
policy statements, speeches of policy committee members, and so forth. To the extent that
policymakers expect to ease or tighten in the future, conveying an expectation that policy rates will
move in a given direction typically will immediately change long-term rates and asset prices in ways
that support the objectives of that policy. That is, longer-term interest rates may move sooner than
would otherwise be the case, in effect reducing the lags in the effect of monetary policy on aggregate
demand.
Expectations, however, can also constrain monetary policy. If policymakers convey, perhaps
unintentionally, expectations of a move at the next meeting, but policy does not in fact deliver that
change, longer-term rates may reverse their earlier move. The only way to avoid surprises is, of
course, always to deliver to the markets what they expect. And surprises are inevitable and desirable
when the market gets it wrong. But concerns about such surprises, especially at times when financial
markets are skittish, may complicate the policy decision.
This tension between encouraging more effective policy by guiding private-sector expectations while,
at the same time, avoiding policy being unduly affected by the very same private-sector expectations,
in my view, was central to the Fed's decision in January 2000 to change the way it communicated to
the market. Before January 2000, the FOMC indicated whether policy was more likely to remain
unchanged or to move in one direction or the other by its choice of a symmetrical or asymmetrical
posture. Thereafter, it communicated only its judgment about the balance of risks to the forecast.
While the latter obviously also had implications for future policy, the new approach might be viewed as
a way to guide expectations while limiting the market's attaching the same degree of immediacy and
certainty to expected future policy actions.
I expect that both panels that follow will discuss the transparency of central banks around the
world - especially those represented on the first panel - and perhaps the degree to which this
transparency contributes to the effectiveness of policy. I hope they will discuss to what extent central
banks can and should guide private-sector expectations about future policy and how they can avoid
situations in which they may feel pressure to ratify private expectations to avoid market disruptions.
This is part of a broader question about the best amount, frequency, and nature of information to
provide the public about the process of setting monetary policy and the details of the debate.