FRBSF Economic Letter
1997-36 | November 28, 1997
On May 6, 1997, the new Chancellor of the Exchequer of Great Britain, Gordon Brown, announced a policy change that he described as “… the most radical internal reform to the Bank of England since it was established in 1694.” The reform granted the Bank of England independence from the government in the conduct of its interest rate policy. In this Economic Letter, I examine how the announcement of the regime change affected expectations about future inflation rates in Britain. In particular, I examine how estimates of inflation expectations, as measured by the spreads on conventional and index-linked British gilts, responded to the May 6 announcement.
A substantial body of economic literature predicts that the more independent a country’s central bank is, the lower the inflation rate is in that economy–in other words, it predicts a negative correlation between central bank independence and inflation. Economists commonly explain this relationship by noting that the general public and its elected representatives tend to prefer expansionary policies. Thus, competent central bankers, who perceive that a tradeoff between real activity and inflation is unattainable in the long run, are better able to conduct a low-inflation policy if they are independent of the government and therefore insulated from political pressure. Several empirical studies (for example, Cukierman 1992) find a negative correlation between central bank independence and inflation rates.
There is some question, however, whether the observed negative correlation reflects a causal link between central bank independence and inflation performance. The observed negative correlations may be spurious, primarily because nations that adopt independent central banks may be those which would exhibit lower inflation rates without them. For example, Posen (1995) argues that opposition to inflation in financial markets is an important contributor to both institutionally independent central banks and the pursuit of low-inflation policies.
The bond market response to the announcement of enhanced independence of the Bank of England addresses this issue directly. Since it is unlikely that other factors, such as financial market opposition to inflation, changed markedly over the period studied, it is fairly safe to attribute observed changes in expected inflation to the change inthe central bank regime.
The policy change gave the Bank of England “instrument independence,” in the sense that it is now free to pursue its policy goals without interference from outside political pressures. However, the government still retains authority to set the goals of policy. As Walsh (1997) points out, the new arrangement is quite consistent with the structure of the new European Central Bank. In particular, monetary policy decisions will now be made by a nine-member Monetary Policy Committee, on the basis of a majority vote. To ensure openness, minutes of proceedings and votes will be published.
Also consistent with the structure of the European Central Bank, but perhaps inconsistent with the notion of independence, the Chancellor made clear that there would be enhanced requirements for the Bank of England to report to the Treasury and the House of Commons on monetary policy. In addition, the Court of the Bank of England will review monetary policy. In his clarification of the policy change before the House of Commons on May 20, the Chancellor made it clear that the government would retain the right to override the operational independence of the Bank in “extreme circumstances.”
A case study of the impact of the May 6 announcement is a test of the joint hypothesis that the announcement was a surprise and that the surprise lowered inflation expectations. There are two reasons why the announcement may not have been a complete surprise. First, there was some belief that Britain eventually would join the European Monetary Union (EMU), particularly after the Labour party took office. If Great Britain joins the EMU, it will be required to grant much greater independence to its central bank, in accord with the design of the European Central Bank, which has price stability as its sole objective and which enjoys complete instrument independence. Second, an independent debate on enhancing central bank independence already was taking place in England. In 1993, the Roll panel released a study calling for central bank instrument independence and a declaration of price stability as the ultimate central bank objective. Despite these caveats, however, it seems clear that the announcement was to some degree a surprise, at least in its timing.
An additional difficulty with attributing any observed changes in inflation expectations to the regime change announcement is that on the same day the Chancellor announced an increase of 25 basis points in the base (or repo) interest rate. Fortunately, there is reason to believe that the interest rate increase was relatively consistent with market expectations. For example, the April 1997 Goldman Sachs UK Economics Analyst reported, “We expect a base rate rise of at least 25 basis points at the 7 May monetary meeting, and an increase of 50 basis points is becoming increasingly likely.” If this report is taken as an indicator of market expectations, the actual increase of 25 basis points would not have been a surprise tightening; indeed, if anything, it might have seemed surprisingly low.
The methodology used to estimate inflation expectations from observed spreads on conventional and index-linked British gilts is described in detail in Spiegel (1998). Basically, the methodology involves specifying an equation for the price of indexed gilts and an equation which incorporates the Fisher identity. The Fisher identity relates the spread between real and nominal interest rates to the level of future inflation. In addition, there are a number of other complications associated with the calculation of these estimates. These include adjustments for lags in inflation indexation, tax issues, coupon payments, and risk premia. These are discussed in detail in Spiegel (1998).
I use three pairs of gilts in the study. They mature in 2001, 2006, and 2016. The estimates of average levels of inflation expected to prevail over the duration of each gilt pair are plotted in Figure 1, with the May 6 event date and the traditional two-week event window highlighted. It can be seen that expected inflation decreased on the event date and indeed over the entire two-week event window. Moreover, these decreases were seen for all three maturities in the study. In contrast, estimates of changes in expected future real interest rate levels (not shown here) were extremely minor.
Since the regime change is a unique event, we conduct a case study by comparing observed changes over the event window to a 120-day pre-event estimation period. I examine three different event periods: one day, two days, and two weeks. The longer-term windows allow for information concerning the regime change which the market acquired with leads and lags relevant to the event date.
For one-day and two-day event windows, the results were strongest for the longest maturity bonds (2016), whose estimate of average inflation declined from 3.85 percent on May 2 to 3.51 and 3.50 percent on May 6 and 7, respectively, a decline of 34 or 35 basis points. Moreover, this represented a ten standard deviation movement relative to changes in expected inflation observed over the estimation period. While this is by no means a formal hypothesis test, it appears quite unlikely that the movement in this series was random noise.
The movements in expected inflation for the shorter maturity bonds were more moderate. Expected inflation for the 2006 bonds declined from 3.80 percent on May 2 to 3.57 and 3.54 percent, respectively, on May 6 and 7, 24 and 26 basis point declines, respectively. The shortest-term 2001 bonds exhibited declines in expected inflation from 3.60 percent on May 2 to 3.45 and 3.44 percent respectively on May 6 and 7, 15 and 16 basis point declines. Despite their relatively more moderate response, these movements were also over two standard deviations as estimated from the estimation period.
The two-week event window examines movements from April 28 through May 13, one week before and after the May 6 announcement. In this case, the movement in expected inflation levels is even larger. Expected inflation declines by 60 basis points for the 2016 bond pair and by 55 basis points for the 2006 bond pair. These movements are greater than five standard errors for two-week window movements over the estimation period. The 2001 bond pair declines by a more moderate 39 basis points.
These results indicate that the market perceived that enhanced central bank independence would lead to lower average rates of future inflation. For the longest-maturity bond pair (2016), average future expected inflation rates decreased by 34 basis points on the day of the announcement and decreased by 60 basis points over the longer two-week event window.
Moverover, these results are not subject to the criticisms that a spurious negative relationship exists between central bank independence and inflation because countries that desire lower inflation rates are also likely to adopt more independent central bank regimes. In this case, it is unlikely that the attitude of the British public towards inflation changed markedly on May 6. The announcement therefore qualifies as a “natural experiment” of an institutional change in central bank regimes. These results, therefore, provide evidence that announcements of institutional changes alone do matter, in the sense that the market priced this institutional change as having a significant impact on future expected inflation rates.
Mark M. Spiegel
Cukierman, Alex. 1992. Central Bank Strategies, Credibility and Independence. Cambridge: MIT Press.
Posen, Adam. 1995. “Declarations Are Not Enough: Financial Sector Sources of Central Bank Independence.” NBER Macroeconomics Annual pp. 253-274.
Spiegel, Mark M. 1998. “Central Bank Independence and Inflation Expectations: Evidence from British Index-Linked Gilts.” Federal Reserve Bank of San Francisco Economic Review 1. Forthcoming.
Walsh, Carl E. 1997. “The Old Lady of Threadneedle Street Gets Her Independence.” FRBSF Economic Letter 97-26 (September 12).
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