Before you read on: in May 1997 the UK government gave the Bank of England a new power. Which?
On 6 May 1997 the Chancellor, Gordon Brown, gave the Bank the job of setting interest rates; the government kept the inflation target.
- The two sides
- Rules: Milton Friedman, Finn Kydland and Edward Prescott, Robert Barro and David Gordon, John Taylor. Discretion: Keynesians such as James Tobin, and central bankers wanting room for shocks
- The question
- Should a central bank follow a fixed rule or its own judgement, and who should set its goals?
- Key works
- Kydland and Prescott, Rules Rather than Discretion (1977); Barro and Gordon (1983); Taylor's rule (1993); Paul Tucker, Unelected Power (2018)
- Where it shaped policy
- Independent central banks, such as the Bank of England since 1997 and the European Central Bank (ECB)
What the argument is about
A central bank sets interest rates to keep inflation low. Under a rule, it responds to the data in a way fixed in advance. Under discretion, it weighs each situation as it arises.
A second question is who should be in charge. In the UK the Bank of England sets rates, and the government sets the inflation target. Paul Tucker, a former Bank of England Deputy Governor, argued in Unelected Power that unelected officials hold such power legitimately only if politicians set them a clear goal the public can monitor.
The two cases
Rules
The case
A central bank free to decide afresh faces a temptation: once wages and prices are set, surprise inflation can cut unemployment for a while. Kydland and Prescott argued that people foresee this, so the economy gets more inflation and no extra jobs. Barro and Gordon modelled the same excess inflation. A rule fixed in advance removes the temptation. Friedman had argued earlier that a steady rule would prevent big mistakes, such as the 1930s money collapse, and would be predictable and hard for politicians to bend.
The evidence it points to
When awarding Kydland and Prescott the 2004 Nobel prize, the committee said their work explains how a country can suffer persistent high inflation even when its stated goal is stable prices, and that it shaped central bank reforms in many countries. The US Federal Reserve now uses rules such as Taylor's as benchmarks.
Discretion
The case
James Tobin, a Keynesian, argued that any rule simple enough to follow cannot foresee every shock, such as the 1970s oil price jumps. Keynesians hold that wages and prices adjust slowly, so active policy can damp the business cycle. Rules also lean on numbers nobody can observe, such as potential output, the most an economy can produce without pushing up inflation, which can only be estimated roughly. Friedman's money rule faltered when financial innovation weakened the link between money and spending.
The evidence it points to
In 2008 and 2009 every rule the Fed tracks called for big cuts, and all but one then prescribed rates below the zero lower bound, further than the Fed judged it could usefully go. The Bank of England cut Bank Rate from 5 per cent to 0.5 per cent within five months, then began quantitative easing (QE), buying bonds with new money. It used QE again in the Covid pandemic.
Ideas from the debate
Can you name the four ideas, two from each side?
A plan that is best when announced stops looking best once people have acted on it, so people expect it to be dropped.
Can you think of an example?
A government vows never to compensate people who build on a floodplain. People expect it to pay out after a flood anyway, so more of them build there.
John Taylor's 1993 formula for the interest rate. The rate rises when inflation is above target, and when output is above the economy's potential.
Can you think of an example?
Inflation runs a point above its 2 per cent target. The rule sets the interest rate about one and a half points higher than if inflation were on target.
The floor, close to zero, under which a central bank cannot usefully cut its interest rate; the Fed calls it the effective lower bound. Rules prescribing lower rates cannot be followed.
Can you think of an example?
In 2009 the Bank of England judged that going below 0.5 per cent would squeeze banks, so it bought bonds instead.
Ben Bernanke's name for a middle way that leans to discretion: a firm commitment to low, stable inflation, with judgement used within that limit to steady output and jobs.
Can you think of an example?
Because people trust the target, the bank can cut rates hard in a slump without stirring inflation fears.