FRBSF Economic Letter
97-36; November 28, 1997
British Central Bank Independence and Inflation
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.
Central bank independence
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
Details of the regime change
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
Difficulties with a case study
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
Estimation of expected inflation
from indexed and conventional bonds
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.
A case study
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
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
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
FRBSF Economic Letter 97-26 (September
Opinions expressed in this newsletter 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. Editorial
comments may be addressed to the editor or to the author. Mail comments
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120