Monetary policy delegation rebounded, and an odd trade-off

Back in the day, monetary policy economists and practitioners discussed the benefits of delgating monetary policy to an independent central bank.

There were two kinds.

The first was to remove an ‘average inflation bias’.  Think of a two period game.  In period 1, the government says to an all encompassing trade union ‘we are going to give you 2 per cent inflation’.  Unions bargain for 4 per cent nominal wage increases to cover productivity and expected inflation.  Once those contracts are locked in, the government surprises the economy with 4% inflation, compressing real wages by 2% and boosting employment, which it thought would help with the next election.  However, knowing the government’s trustworthiness, or lack of it, in advance, the union would bargain for 4% plus productivity.  This forced the government’s hand right from the off to generate 4% inflation, or suffer a real wage increase and lower employment.  Delegation to an independent central bank prevented the surprise inflation.

A similar argument held for how the government had an incentive to under-smooth inflation shocks, even once the question of the average level of inflation was resolved.   If it promised to curb them greatly, it could manipulate inflation expectations advantageously.  Delegation was supposed to sort that too, leading to lower inflation variability [and a better trade-off between that and output variability].

Armed with these theoretical results, the observation of lower and apparently less variable inflation in the 90s and 00s was therefore put partly down to this delegaion and assignment.

However, with hindsight, it’s possible to see that the whole thing has rebounded.  By being too ambitious to curb the inflation bias, setting inflation targets that were too low, governments lowered the resting point for central bank rates too far, leading to the zero bound trap being encountered after the 2008/9 crash [with a close run before in the early 2000s, and of course Japan falling foul much earlier].  At this point, monetary policy instruments, conventional and unconventional, having lost their firepower, the job of stabilizing the economy rebounded back to the government, along with the old credibility problems that went with it.

The experience also highlights a peculiar trade-off.  The more you try to squeeze down inflation at the point of instrument assignment, the less successful delegation ultimately is, [the more likely the zero bound trap is fallen into subsequently].

If you don’t believe that central banks need to smooth business cycles, or you think they do more harm than good by trying, you’re likely to think of this not as an unfortunate consequence of targeting too low an inflation rate, but as a stroke of good fortune that leads a society deluded by New Keynesian macro into following the dictum of the Friedman Rule, whereby interest rates are pegged at zero and the penalties for holding non-interest bearing money are eliminated.

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