How Other Central Banks Work

Article excerpt

A nation's ability to control inflation depends on the structure of its central bank and the relationship between the central bank and the government.

Anation's ability to control inflation depends on the structure of its central bank and the relationship between the central bank and the government. Central banks vary widely in their structure and effectiveness at maintaining price stability.

Perhaps the best way to shield an economy from inflation is to make the central bank independent and give it a legally binding mandate to achieve price stability. Central bank independence can protect the nation from opportunistic politicians desirous of extracting short-run gains from price increases if the central bank's objectives and technical competence cause it to pursue the common good more consistently than would a partisan political government.

Empirical research suggests that more-independent central banks produce lower inflation. A legal directive reflecting the long-run goals of society would reduce a central bank's own inflation bias. A combination of a clearly stated goal and the freedom to achieve it without government interference might be referred to as operational independence.

The first country to formally introduce inflation targeting was New Zealand. The Reserve Bank of New Zealand Act of 1989 statutorily binds the bank to price stability. The target is the result of negotiations between the central bank head and the finance minister. To give the act clout, the head of the central bank can be fired if he misses his objective. The central bank has had some success in meeting its ambitious target.

Other countries have recently introduced legislation aimed at increasing their central bank's operational independence. In June 1997, the Bank of England was given an inflation target and independence to carry it out (although the government may overrule the bank in exceptional circumstances.) This was formalized in the Bank of England Act of June 1998.

June 1997 also saw the enactment of the Bank of Japan Law, which gave the Bank of Japan greater independence and ordered it to pursue low inflation. As a result, government officials no longer sit on the bank's monetary policy committee and cannot instruct the bank. No explicit inflation targets were set, however.

The importance of the euro

Eleven European countries--including Germany, France, and Italy--have formed a monetary union and adopted a common currency called the euro. Euro notes will be introduced in January 2002, and national currencies will lose their legal tender status in July of that year. A common monetary policy is now made by a new central bank, the European Central Bank (ECB). The Maastricht Treaty and its annexed protocols describe the institutional structure and policy of a common central bank.

The treaty makes the central bank highly independent but is more ambiguous about its policy prescription than is the Bank of England Act. It proscribes the ECB from both asking or receiving advice from member countries' governments. It calls for price stability to be the ECB's main objective but does not set an inflation target. Instead, the bank has adopted its own.

In contrast, although the Federal Reserve is relatively independent, the U.S. monetary arrangements do not give overriding importance to price stability. The Fed is not given an inflation target (by law, by the executive, or by Congress), and it does not set its own inflation target.

The Federal Reserve Act lays out the goals of monetary policy. It specifies that, in conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee (FOMC) should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The Fed is unique among modern central banks in having "maximum employment" (whatever that may mean) on a par with price stability and moderate long-term interest rates among its objectives. …