Credibility

The key goal for monetary authorities is credibility:

1. Independent central banks. One option is to outsource mone- tary policy to a group of independent economists. In 1997 the then Chancellor Gordon Brown granted operational independence to the Bank of England. This was a major policy to signal to markets that the Labour Party could be trusted with the economy. Unlike politicians, the Bank of England’s Monetary Policy Committee (MPC) were less tied to short termism or populism. The problem with this is that the scope of independence is relatively narrow, and when there is a lot of attention on the central bank – for example during a financial crisis – it can become a politicized institution. Ultimately if a country has a very low level of credibility then hand- ing policy decisions over to economists is unlikely to make much difference, and bigger steps are required.
2. Fixed exchange rates. If a country has a major credibility problem it can outsource its monetary policy to a different country, and fix their exchange rate. In this way they can piggyback on the credibility of the country they fix their exchange rate to. They can choose to fix the exchange rate to a single currency, or to a basket of currencies (perhaps weighted by how much trade they do with those countries). A currency board is when the monetary author- ity maintains a fixed exchange rate and holds 100% reserves. This doesn’t completely solve the credibility problem because it’s still possible for them to abandon the fix, but it may be easier to commit to the fix than to low inflation.
3. Currency union. An even more extreme regime is when multi- ple countries adopt the same currency. This gives individual coun- tries even less scope to manage their own affairs, which increases their credible commitment to controlling inflation. Again, the credibility lies in the expected permanence of the arrangement.
4. Commodity standard. All of the above still rely on the gov- ernment managing the money supply. Historically though this is a relatively new phenomenon. An alternative is to use some type of commodity as money. In the nineteenth century there was a government administered gold standard that tied the value of cur- rency to the price of gold. But does government need to be involved at all?

In “Is China better at monetary policy than America“, The Economist, April 22nd 2023, we are reminded that central bankers tend to be conservative – the technical term is “attenuation”, “if policymakers are uncertain about the effects of their own policies, they should do less than they otherwise would. In other words, if you are not sure of the potency of your medicine, administer less than you would if you were”. However, The Economist reports the problem with this, which is that markets, “will come to expect this stodginess and adjust their actions accordingly. If inflation gets out of whack, they will expect an inhibited response and, as a consequence, a more persistent misalignment of inflation”.

For a recent survey of the improvement in emerging market monetary policy due to central bank independence and inflation targeting, see “Laboratory accidents“, The Economist, March 11th 2023. It also reveals how increased reliance on non traditional tools may undermine this.