Subject: Paper on inflation targeting and central bank independence
From: Willem H. Buiter (willembuiter@btinternet.com)
Date: Mon Jul 10 2006 - 14:44:18 EDT
Colleagues,
On June 23, 2006, I presented a paper at the 2006 Central Bank Governors'
Symposium "Challenges to Monetary Theory", at the Bank of England. The
title of the presentation was:
"How Robust is the New Conventional Wisdom in Monetary Policy? The
surprising fragility of the theoretical foundations of inflation targeting
and central bank independence".
The (much) longer paper on which this presentation was based can be found at
the following URL: http://www.nber.org/~wbuiter/konstanz.pdf
Here is the abstract of the paper:
Abstract
Flexible inflation targeting - the minimisation of the expected discounted
sum of current and future period losses, with the period loss function given
by the weighted sum of squared deviations of inflation from a constant
target rate and the squared output gap - cannot be rationalised, except in a
single, practically uninteresting special case, using conventional welfare
economic criteria. Woodford's assertion to the contrary, based on
New-Keynesian dynamic stochastic general equilibrium models, is generically
incorrect for that class of models. These New-Keynesian models imply that
optimal monetary policy implements the Bailey-Friedman Optimal Quantity of
Money rule and that actual inflation fully validates or accommodates core
inflation - the inflation generated by rule-of-thumb price and/or wage
setters.
Flexible inflation targeting is also inconsistent with the mandates of
leading inflation targeters like the Bank of England and the ECB. These
mandates are lexicographic in price stability (from now until Kingdom Come)
and all other objectives, with price stability in pole position. A
lexicographic mandate does not permit a trade-off between inflation
volatility and output gap volatility in the monetary policy maker's
objective function. A lexicographic ordering of the price stability
objective for the monetary authority makes sense even if, for whatever
reason, the true objective function were of the flexible inflation targeting
variety. This is because there is no evidence that monetary policy can
systematically contribute to output gap stabilisation beyond what is the
natural by-product of the single-minded - lexicographic - pursuit of price
stability in the medium and long term.
Operational independence of the central bank is limited by the central
bank's intertemporal budget constraint. Price stability, or an externally
imposed inflation target, may not be independently financeable by the
central bank. In that case, active budgetary support from the Treasury is
necessary to make the inflation target financeable.
Independent monetary policy is fully compatible with coordinated and
cooperative monetary and fiscal policy.
Central bank operational independence precludes substantive accountability;
it is compatible only with a weak form of formal accountability: reporting
obligations.
Central bank independence will only survive if it is viewed as legitimate by
the polity and its citizens. A necessary condition for this is that the
central bank restricts its activities and public discourse to its natural
core mandate: price stability and the capacity and willingness to act as
lender of last resort. The Protocol on the Statute of the ESCB and the ECB
has given the ECB a mandate that goes beyond this natural core mandate, by
assigning the ECB a key formal advisory role in the quintessentially
political process of Eurozone enlargement. Furthermore, the ECB follows a
long-established continental European tradition of central banks routinely
and vocally participating in the public debate on fiscal sustainability and
structural reform. These are areas that are both beyond the ECB's (already
over-ambitious) Treaty-based mandate and beyond its domain of competence.
Such behaviour represents a threat to its continued independence.
Comments would be most welcome.
Willem
Professor Willem H. Buiter CBE, FBA
Chair of European Political Economy,
European Institute
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
United Kingdom
Tel.: + 44 (0)20 7955 6959
Fax: + 44 (0)20 7955 7546
E-mail: w.buiter@lse.ac.uk
Web: http://www.nber.org/~wbuiter/
