Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1997-26 | September 12, 1997

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The Old Lady of Threadneedle Street Gets Her Independence

Carl E. Walsh

The Bank of England, established in 1694, is one of the world’s oldest central banks. It is affectionately known as the “Old Lady of Threadneedle Street,” having operated continuously at that location in the City of London since 1734. During its long history, the Bank has witnessed many significant events, but May 6, 1997, will undoubtedly be remembered as one of the most important. On that day, just three days after taking office with a landslide majority in Parliament, the Labour government of Prime Minister Tony Blair gave the Bank its independence. The announcement, made by George Brown, the new Chancellor of the Exchequer, aligned the U.K. with the growing number of countries around the world that have instituted central banking reforms designed to reduce the direct role of elected political officials in the conduct of monetary policy.

Before Chancellor Brown’s announcement, there had never been any doubt that the Bank of England was controlled by the elected government. Changes in the short-term interest rate used as the instrument of monetary policy had to be approved by the Chancellor of the Exchequer – the Bank could not independently initiate policy actions. Under the new regime announced by Chancellor Brown, it will now be the Bank itself that decides on the stance of monetary policy. And in the nearly four months since gaining independence, the Bank has raised interest rates on four separate occasions. In this Economic Letter, the Labour government’s moves are compared to other proposals for greater central bank independence, and some of the reasons for the changes to the U.K.’s new monetary policy framework are discussed.

Moves Towards Central Bank Independence

The arguments for making central banks independent of direct political influence have been reviewed in earlier Economic Letters (e.g., Walsh 1994). Among the industrialized economies, inflation over the past 30 years has averaged lower in nations with politically independent central banks. The most independent central banks, those of Switzerland and Germany, have delivered among the lowest average inflation rates. Equally important, greater central bank independence is not associated with any decrease in average real economic growth or with an increase in economic fluctuations. At the same time, central bank independence is not necessary for low inflation — Japan is a case in point with historically a very dependent central bank and low average inflation. Thus, there are questions about the evidence that central bank independence causes low inflation; nevertheless, there has been a worldwide movement to grant central banks increased independence in the hopes of achieving, and maintaining, low rates of inflation. The U.K. is only the latest to join the club.

In Europe, central bank reform was a cornerstone of the 1992 Maastricht Treaty, which laid the foundation for eventual monetary union among the members of the European Community. The Treaty outlined the structure of the proposed European Central Bank (ECB) as a politically independent authority modeled on Germany’s Bundesbank. The ECB’s primary objective will be price stability, and the ECB will be explicitly prohibited from taking instructions from member governments of the European Community. It must, however, issue quarterly reports and present an annual report to the European Parliament. This structure is designed to restrict significantly the role of elected governments in setting monetary policy.

The Maastricht Treaty also required that member countries reform their own central banking laws to make national central banks more independent. The Banque de France, for example, was given increased independence in 1994. Central bank reforms have not been limited to Europe, however; countries ranging the globe from New Zealand to Mexico and even Japan have implemented, or are considering implementing, measures to increase the independence of their central banks.

The Road to the Old Lady’s Independence

Despite these worldwide movements towards central bank independence, the former British government had consistently refused to grant the Bank of England its formal independence. John Major’s Conservative government did, however, introduce incremental changes that altered the Bank of England’s role in policymaking. The most prominent change was the publication of the minutes of meetings between the Governor of the Bank of England and the Chancellor of the Exchequer. By making public any disagreements between the Bank and the government, the voice of the Governor in advocating lower inflation was strengthened. While the Chancellor retained ultimate authority for setting interest rates, the Bank was provided with a means of publicly revealing any disagreement about monetary policy and interest rate levels. The Bank was also directed to produce quarterly inflation forecasts, which gave the Bank an additional forum to publicize its assessment of current policy.

More far-reaching reform of the Bank of England was advocated in a report published by the Centre for Economic Policy Research (1993). In this report, a panel of experts headed by Lord Eric Rollproposed (1) that an Act of Parliament specify that price stability be the sole objective of the Bank of England, (2) that the Bank be required to announce short-term inflation targets, and (3) that the Bank have complete instrument independence. Such a structure would have provided the Bank with both goal independence (the freedom to set short-run policy goals consistent with price stability) and instrument independence (the freedom to set short-term interest rates to achieve its policy goals).

These recommendations closely follow the structure proposed for the European Central Bank (ECB). A single objective, price stability, is established formally, with the central bank having short-term goal independence (consistent with the ultimate objective of price stability) and instrument independence in achieving its inflation targets. The major difference between the Roll Panel proposal and the Maastricht Treaty proposal lies in the treatment of accountability. The ECB will not be required to establish short-run inflation targets, nor will it be formally accountable to any elected officials. The Roll Panel called for public inflation targets set by the Bank of England, with the Bank required to report regularly to a select committee of the House of Commons. This would allow the Bank to establish policy goals but would maintain a degree of accountability in that the Bank would need to justify its actions to Parliament.

The degree of independence actually granted to the Bank of England by the Labour government differs from that recommended by the Roll Panel and from that contained in the Maastricht Treaty. The Bank can set its policy instrument in the manner it views as best able to achieve its policy goals, but the Bank was not given the independence to sets its own policy goals. The government has retained authority to set the goals of monetary policy, which it will do through the establishment of a target for the rate of inflation. The Bank of England will then be charged with using its new instrument independence to achieve the government-set target. Thus, accountability for policy will be enforced through Parliamentary debate and elections, while the Bank will be accountable to the government for the actual implementation of policy.

Why Labour?

Britain’s new government is certainly not the first example of a Labour government deciding to allow its central bank increased independence in conducting monetary policy. One of the earliest in the recent wave of central banking reforms occurred in New Zealand, where it was the Labour government that introduced the Reserve Bank Act of 1989 which granted broad independence to New Zealand’s central bank. In both New Zealand and now the U.K., left-of-center political parties sponsored major policy reforms aimed at raising the importance of low inflation as a policy objective.

Such actions by left-of-center political parties, and not by right-of-center parties who might more typically be viewed as sympathetic to low-inflation policies, are consistent with theories that stress the importance of reputation in maintaining a low-inflation environment. Actual inflation depends, in part, on expectations of inflation, since price and wage setting decisions in the economy will be based on the likely outlook for future inflation. As a consequence, a government viewed as weak on inflation may engender expectations of higher future inflation that make the task of maintaining low inflation more difficult. A government with more credibility as being tough on inflation will have an easier job, as expected inflation remains low. This argument suggests that governments who might be perceived to be weak on inflation will actually have the most to gain from granting the central bank its independence, thereby insulating monetary policy from direct political pressures to pursue short-run expansionary policies.

Will the Reforms Matter?

Will these changes to the power of the Bank of England make a difference for inflation? The immediate verdict of the financial markets was that it would. Figures 1 and 2 show the spread between long-term interest rates in the U.K. and rates in Germany and the U.S. Movements in long-term interest rates often are interpreted as predominately reflecting variations in expected future inflation (Rudebusch 1997), and, for that reason, the Maastricht Treaty requires countries joining the European single currency to have a long-term interest rate spread of 2% or less with the three lowest inflation members. The sharp drop in interest rate spreads that occurred immediately upon the government’s announcement of the new monetary policy structure provides clear evidence that market participants expect lower future inflation in the U.K. as a result of these changes. Based on the evidence from other countries, the new independence of the Bank of England should result in a lower average rate of inflation in England over the next few years, while avoiding any adverse impact on real economic growth.

However, it also has been argued that independent central banks are successful in maintaining low inflation only because their independence reflects a social or political consensus in support of low inflation. According to Posen (1995), for example, central bank independence reflects the strength of anti-inflation interest groups. He concludes that attempts to establish central bank independence in the absence of underlying political support for low inflation will not be successful. If true, this may indicate the need for caution in interpreting the effects of the Bank of England reforms. By failing to raise central bank reform as an issue during the election, and waiting instead to announce the changes in a post-election surprise, the Labour government may still need to build the political consensus and popular support for low inflation that will be necessary to ensure the long-term independence from political manipulation of monetary policy in the U.K.

Carl E. Walsh
Professor of Economics, U.C. Santa Cruz
and Visiting Scholar, FRBSF


The Centre for Economic Policy Research. Independent but Accountable: A New Mandate for the Bank of England, October 1993.

Posen, A. “Declarations Are Not Enough: Financial Sector Sources of Central Bank Independence.” In NBER Macroeconomic Annual 1995, eds. B. Bernanke and J. Rotemberg, pp. 253-274. Cambridge: MIT Press.

Rudebusch, G. “Interest Rates and Monetary Policy.” FRBSF Economic Letter No. 97-18, June 13, 1997.

Walsh, C.E. “Is there a Cost to Having an Independent Central Bank?” FRBSF Economic Letter No. 94-05, February 4, 1994.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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