There has been a long-drawn debate over whether the monetary policy decisions should be governed by rules or discretion. However, neither pure discretion nor adherence to an intermediate monetary target has proved satisfactory. Instead, several countries are moving toward a regime in which there is a clear target for achieving the ultimate objective of the monetary policy.
There are three broad phases in the approach to policy making in the postwar period. Until the late 1960s, it was taken for granted that formulating a monetary policy required a substantial amount of discretion. From the early 1970s to the 1980s there was a growing emphasis on rules. By the late 1980s, however, there was a swing away from the rules-based policy regimes. The relationship between intermediate targets and ultimate objectives became more variable under the influence of financial liberalisation and innovation. In recent years it seemed most central banks recognised the need for a return to greater discretion in use of monetary instruments.
In this context, it is necessary to give definition of a few terms, because the same expressions may be used to mean different things by different authors. Central banks use policy instruments to pursue ultimate policy objectives. Along the way they are concerned with intermediate variables which are part of the policy transmission process as well as with indicator variables which may provide information about the policy impact, without themselves being part of the transmission mechanism.
Rules are generally taken to require the authorities to use the monetary policy instruments to take a given predetermined path for an intermediate variable (usually a monetary aggregate). Intermediate variables are those which the monetary authorities may attempt to target because of their presumed relationship with the ultimate objectives of the monetary policy. The most common example of an intermediate variable is the money stock or credit stock. To the extent that growth in monetary aggregates is stably related to the ultimate objective of monetary policy (the steady growth of the nominal value of output) and to the extent that it is more feasible to control the money stock than nominal output, it makes sense to direct policy instruments towards the achievement of an intermediate variable.
Indicator variables can be defined as those that have information value about the impact of an instrument on policy outcomes but are not themselves an object of control. In fact, the whole range of economic quantities has a bearing on monetary policy decisions. They can include variables that in another context may be viewed as an intermediate target. For example, the growth of money stock can be regarded as an object to be controlled. It can also be regarded as one indicator (among others) of the potential strength of demand in an economy. This underlines an important point. That a monetary variable is not used as an object of control does not mean that it does not play an important role in evaluating the stance of a monetary policy.
Other indicator variables are those that convey information about the future of the economy and the balance between inflationary and recessionary forces. They include all variables relating to the current and prospective level of real economic activity (growth in gross domestic product-GDP, industrial production, retail sales, consumer and business spending surveys, etc.). They also include cost and price indicators (wages, import costs, consumer and producer price indices) and expectation indices, including expectations derived from financial variables such as the shape of the yield curve. The distinction between whether variables are to be treated as indicators or intermediate targets is crucial to the distinction between rules and discretion. However, the distinction between rules and discretion is not straightforward and hence deserves some clarification. The use of discretion in monetary policy is clearly not intended to imply randomness in decision making. A discretionary policy action usually reflects a systematic response by policy authorities, in the light of their objectives and their perceptions as to how the economy will respond to particular economic stimuli.
ARGUMENTS FOR DISCRETION IN POLICY FORMULATION AND IMPLEMENTATION: First, in economics there are both supply shocks and demand shocks. The appropriate monetary policy response will be quite different in the two cases. If the authorities can identify the nature of different shocks, they will be able to improve welfare by exercising discretion as to how they will respond to them. A second argument for discretion lies in the fact that the speed with which an economy returns to price stability following an inflationary or deflationary shock has implications for output and employment. The use of discretion may enable the central bank to tolerate some overshooting of the monetary targets to allow the return to price stability to take place in a more orderly manner. A third argument for discretion is that the structure of the economy is changing with the passage of time in ways that cannot easily be predicted in advance. The relationship between intermediate variables and the ultimate objectives of a policy can be affected by technical developments. Under such circumstances discretion, rather than a set of rules, could be more appropriate.
ARGUMENTS FOR RULES: One view is that, in a democracy, discretion in decision making should be removed from individuals and vested in rules and laws. Perhaps, the more important economic argument for rules is that there is fundamentally stable relationship between an intermediate variable (a monetary aggregate) and the ultimate objective of a monetary policy (the growth of nominal income). The benefits of discretion are, therefore, small, since it is not possible to improve much of the outcome generated by adopting a stable money growth target. On the other hand, the costs of discretion are potentially large.
A subsidiary argument for rules is that financial markets operate most efficiently in the presence of certainty. If in addition to the inherent uncertainties generated by outside economic shocks, there are uncertainties about the authorities' policy response, the difficulties faced by markets will be compounded. This argument has been formalised in the literature of the time consistency problem and the value of rules that pre-commit the authorities to a particular course of action. The arguments in favour of rules are based more on the quality of discretionary action than on discretion. It may be argued that a discretionary monetary policy is subject to two systematic sources of adverse bias: too little, too late. For example, there will be greater willingness to lower interest rates than to raise them.
THE CENTRAL BANK'S INDEPENDENCE - RATIONALE AND REALITY: One of the primary tenets of accepted central banking thoughts has been the importance of keeping central banks politically independent. No other aspect of central banking has evoked more attention and discussion than the advocacy on making the central bank independent of any political authority. The concept of an independent central bank favours separating the power of creating money from the power of spending the money. Hence, the strongest argument for an independent central bank rests on the view that subjecting the central bank to more political pressure would impart an inflationary bias to the monetary policy. As argued by many observers, politicians in a democratic society are short-sighted, because they are driven by the need to win their next election and they are unlikely to focus on long-term objectives, such as promoting a stable price level. Instead, they will seek short-term solutions to problems, even if the short-term solutions have undesirable long-run effects. A politically-insulted central bank is more likely to be concerned with long-term objectives and thus be a defender of a sound currency and a stable price. Putting the central bank under the control of the government is considered dangerous, because the central bank can be used to facilitate financing large budget deficits and thus this help might lead to a more inflationary bias in the economy. An independent central bank is better able to resist this pressure from any government expenditure without raising taxes. An independent central bank, largely free from political pressure, is needed to ensure justice to those who lose from inflation.
Another argument for a central bank's independence is that the conduct of a monetary policy is too important to leave to politicians who may lack the expertise about making tough decisions on issues of great economic importance, such as reforming the banking system, or reducing the budget deficit. The crucial parameters like price level and exchange rate under no circumstances should be transferred to the political control variable. But removal of the monetary policy from the political sphere is itself a political act. There seems to be an even stronger case for an independent central bank in the developing countries, given the greater frequency and arbitrariness of political change coupled with politicisation of finance. A recent research demonstrates that political instability causes instability at the central bank too, although the spillover effect varies from country to country. These are the questions which have not been addressed in the debate on the central bank's independence.
According to some experts, an autonomous central bank is necessary in Bangladesh to conduct a sound monetary policy and exercise utmost prudence in such matters such as licensing new banks and the use of directed credit. Experience with government intervention in these matters in Bangladesh underlines the importance of establishing an autonomous central bank in our country. The boards of directors of state-owned banks and financial institutions need to be constituted with people having sound knowledge about the national economy and the financial sector. However, the Bangladesh Bank has not been given any authority to appoint independent directors to private banks under the recently-amended Banking Companies Act 2013. The Bangladesh Bank can remove MDs of state-owned banks but has no such authority, when it comes to the boards of directors. A strict application of the criteria set by the Bangladesh Bank for selection of qualified persons with good reputation and right professional profile for boards of directors in state-run banks is needed so that the directors in the state-run banks can perform up to the desired level of competence to keep the banking system on the right path.
However, the central bank must show an objective and independent attitude to various sectors and interest in the economy and it should earn a reputation for impartiality. The personality, prestige and the competence of the central bank management in any country can go a long way in persuading the banks and the government to formulate and implement an appropriate monetary policy for a country.
THE CASE AGAINST INDEPENDENCE OF CENTRAL BANK: Proponents of the government's control of the central bank argue that it is undemocratic to have a monetary policy (which affects everyone in the economy) formulated by an elite group responsible to none. The people hold the president or parliament responsible for the economic well-being of the country, yet they lack control over the government agency, the central bank that may well be the most important factor in determining the health of the economy. The monetary policy involves difficult decisions from a long-term perspective. The public hold the government responsible for the economic conditions that result from all the policies followed by the government. Hence the government should have control over the monetary policy. It seems to be undemocratic to say that elected officials, in a parliamentary democracy, should not be trusted to judge the monetary policy. Monetary and fiscal policies should be integrated and adequate integration cannot be achieved merely by a process of informal consultation. Rather it requires that the central bank becomes part of the administration. Giving the government control over the central bank does not necessarily call for weakening its influence, rather strengthening it. If it was a part of the administration, the central bank advice could then be better heeded by the government. However, there is yet no consensus on whether an independent central bank is a good idea, although the public support for independence of a central bank seems to have been growing in different countries of the world.
The arguments for and against independence of a central bank may give the wrong impression that the choice is between two irreconcilable extremes. But this is not so. Even if the central bank was to lose its formal independence and become a part of the government administration, there could still be an attempt to keep it out of partisan politics.
The writer is a Professor of Economics at the Faculty of Business and Economics, Daffodil International University. [email protected]