Since its departure from the ERM in September 1992, the UK government has sought a new anchor for its monetary policy. By the end of 1992 the pursuit of price stability had been proclaimed, the government had announced a tough medium-term objective for inflation, and it had offered the Bank of England a monitoring role through publication of the Bank's Inflation Report. This new system has so far had an easy ride: in a slow recovery from a deep recession, inflation has been low in spite of substantial exchange rate depreciation. The pressure will increase, and eventually a policy framework with a stronger monetary anchor will be required.

A more independent Bank of England might provide the right anchor, according to a CEPR Report from a Panel chaired by Lord Roll. Empirical research reveals that countries whose central bank is more `independent' (measured by the rules for appointing officers and setting interest rates) enjoy lower inflation, at no cost in terms of lower growth. This relationship represents correlation, not necessarily causation: both low inflation and central bank independence may be due to the same underlying political and economic forces. But recent theory stressing monetary policy credibility also suggests that a more independent Bank of England would provide the UK with sustained low inflation.

There is more than one model for an independent central bank. New Zealand and Germany represent the polar cases. Germany relies on the constitutional independence and reputation of the Bundesbank, which has a free hand in implementing its mandate. The New Zealand approach rests on an explicit contract governing the setting of targets and conduct of policy. In New Zealand, price stability is the only objective of the central bank, while in Germany the Bundesbank is also obliged to support the government's general economic policy objectives (provided this does not conflict with price stability). In New Zealand targets for inflation are agreed jointly by the government and the Central Bank governor as part of the contract negotiations, while in Germany the Bundesbank establishes its own targets for inflation.

The form of central bank independence varies across countries. In Germany, the electorate has a deep preference for price stability. The penalty for letting inflation get out of control will befall on government as well as on the central bank. In such a setting, it is possible to delegate considerable discretion to the Bundesbank, whose `independence' is then as much a symptom as a cause of widespread concern for price stability. The preferences of the UK electorate are much less clear:

The panel considered whether price stability should be the sole objective of an independent Bank. The Bundesbank may cope with more than one objective, but a multiplicity of objectives can obscure monitoring and the accountability of an independent central bank. Given the UK's inflationary history, the New Zealand approach of a single, easily monitored objective is likely to work best.

Procedures for setting targets are also an important aspect of independence. The New Zealand model allows the government a role in setting the medium-term target for inflation. According to the Report, this model is unlikely to work well in the UK: a gradual erosion of monetary discipline through an upward drift of targets is only too likely, given the historical tolerance of inflation in the UK.

With these national characteristics, the best system for the UK is one that emphasizes transparency, monitoring and accountability rather than the Bundesbank model, which relies more on reputation and trust. The Panel argues that the UK has already begun to travel down this more transparent road: the government announces a target range for inflation, and the Bank is invited to monitor progress in its quarterly Inflation Report.

The Report's proposals for the UK borrow features from both the New Zealand and the German models. Price stability should be the sole statutory objective of the Bank. The Bank, not the Treasury, should formulate and announce a medium-term target for inflation and would control short-term interest rates to achieve this target. The Bank would need full control of interest rates to pursue price stability. Given interest rates, foreign exchange markets will determine the exchange rate. Neither the Treasury nor the Bank can have any `exchange rate policy' distinct from that implied by the Bank's obligation to pursue price stability.

Would a more independent Bank of England reduce public and parliamentary accountability for monetary policy? Quite the contrary, say the Panel. Such accountability is very limited in Britain at present. Parliament has few opportunities to scrutinize the conduct of monetary policy. A statutory basis for the objectives of a independent Bank would enhance democratic control, by providing legislative standards against which subsequent policy can be judged. The Governor would have to give a regular account of the Bank's choice of inflation target and its interest-rate decisions to the House of Commons Treasury and Civil Service Select Committee, which already considers macroeconomic policy. Since monetary and fiscal policy interact, the Bank, in accounting for its own behaviour, would inevitably have to discuss how its options were constrained by government policy. Such an investigation would inform debate, both within Parliament and outside.

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