International Finance 3:3, 2000: pp. 375–389
Monetary Policy Design: Institutional Developments from a Contractual Perspective Carl E. Walsh* University of California, Santa Cruz.
Abstract Twenty years ago, most industrialized economies were just starting the costly process of disinflation. There was little consensus that these disinflations would be successful, or that low inflation once achieved could be maintained. While the USA achieved low inflation without changing its policy making institutions, many other countries did reform their central banking institutions, making them more independent of political influences. In this paper, I address three questions. First, is independence enough? Second, how do the details of an institution’s structure translate, through their impact on incentives, into different policy outcomes? And third, can institutions serve as commitment mechanisms?
I. Introduction Twenty years ago, most industrialized economies were just starting the costly process of disinflation. There was little consensus that these disinflations would be successful, or, if they were, that low inflation once achieved could be maintained. Indicative of the times, Karl Brunner introduced a volume on *Any opinions expressed are those of the author and are not necessarily those of the Federal Reserve Bank of San Francisco or the Federal Reserve System.
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The Federal Reserve Authorities and Their Public Responsibility, by noting (Brunner 1980): A searching evaluation of the institutional context influencing the Federal Reserve’s established bureaucracy yields little hope for a substantial change in our monetary policymaking over the longer horizon. The problem of formulating and implementing a rational monetary policy thus continues to plague us in the future – and the failure to cope with it will appear as a permanent and erratic inflation imposing a large social cost on the citizens of this country. It is ironic that this statement was made just as the USA entered a period of disinflation that has been followed by a sustained period of low inflation. This was achieved with no change in the institutional structure of the Federal Reserve. The twenty years since Karl Brunner made that statement have witnessed, by most accounts, a rational monetary policy. While the USA achieved a rational monetary policy without changing its monetary policy institutions, many other countries did undertake central banking reforms. The last decade of the twentieth century witnessed numerous reforms and institutional changes in central banking structures among the industrial and developing economies. The best-known early reform was that embodied in New Zealand’s 1989 Reserve Bank Act (Walsh 1995b), but the 1990s saw many other countries rewrite the governing legislation for their central bank. These reforms have reshaped the institutional structure within which monetary policy is conducted. It is not just existing institutions that have been reshaped. The creation of the European Central Bank provided an opportunity for an entirely new monetary policy institution to be created. The shape it took reflected current thinking among politicians, central bankers and academics about the connection between institutional design and policy outcomes. Is there a set of institutional features that are necessary to sustain a rational monetary policy? A division exists among academic economists over the answer to this question. On the one hand, economists in the new political economics literature emphasize the importance of incentives, political influence and public perceptions of the policy making process. They view central banks as behaving optimally but sequentially, given the institutional environment in which they find themselves. On the other hand, economists devote time and energy to deriving optimal commitment rules that are ‘institutional and political free’, essentially arguing that central bankers who wish to follow such rules ‘can just do it’ (McCallum 1995, p. 209, emphasis in original), even if ‘doing it’ is not sequentially rational. If central banks behave in a discretionary fashion, then social welfare may be lower than it would be if the central bank © Blackwell Publishers Ltd. 2000
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could credibly commit to an optimal rule. If discretion is the more realistic description of the policy process, then policy outcomes may be improved if the central bank’s incentives are altered. Changing the institutional framework is one way of doing this. A natural way to think about institutional reform, and the impact reforms might have on policy outcomes, is provided by principal–agent theory. Society, or perhaps an elected government, may grant the central bank independence, alter the process through which central bankers are appointed, establish inflation targets, or require the central bank to make certain announcements. These aspects of the policy environment represent a type of contract with the central bank. Viewed in this light, it is natural to ask how institutional reforms actually affect central bank incentives and policy choices. Are there reforms that promote rational monetary policies? Perhaps the academic uncertainty over the role of institutional reforms is not surprising, reflecting as it does a weakness in our knowledge of how institutions behave. Knowing whether a specific set of institutional structures is necessary for good policy, or whether a variety of policy structures can support the same good policies, requires a clear understanding of the linkages between institutional design and policy outcomes. As Lohmann puts it, ‘the mapping of interests onto monetary policy outcomes, as it is shaped by monetary institutions, is not straightforward’ (Lohmann 1998, p. 444), and because economists have not yet developed models that can provide the type of tight connection between specific institutional details and observable outcomes that would allow for clear empirical testing, it is difficult to know whether (or which) institutional details really matter. Despite this academic uncertainty over the consequences of institutional reforms, many central banks have been revamped. While the exact details of reform have varied from country to country, two aspects have been shared by all. First, the reforms have aimed to reduce the role of elected governments in the day-to-day conduct of monetary policy. Increased central bank independence has been a chief outcome of reform. Second, the objectives of monetary policy have been clarified. Price stability, or some variant such as low and stable inflation, has emerged as the primary or sole objective of policy. In the useful terminology of Debelle and Fischer (1994), these two aspects of reform have, in the first case, led to greater ‘instrument’ independence, while in the second case, they have produced less ‘goal’ independence. While the contracting approach provides a way of thinking about incentive structures, three questions arise. First, is independence enough? Many economists have argued that a nation need only ensure that its central bank is adequately protected from political influences. The central bank can then simply do the right thing – no further institutional reforms are needed. © Blackwell Publishers Ltd. 2000
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Second, how do the details of an institution’s structure translate, through their impact on incentives, into different policy outcomes? And third, can institutions serve as commitment mechanisms? These are the issues I will discuss. Because my focus is on objectives and incentives, I will not discuss the implications of technological change for central banks. This is the focus of Friedman (1999) and it is addressed by some of the other papers discussing that argument in the July 2000 issue of this journal. Friedman argues that the disappearance of traditional components of the monetary base will render open market operations ineffective in controlling interest rates. In contrast to this position, Woodford (2000) argues that central banks can continue to affect market interest rates, although doing so may require central banks in some countries (including the USA) to change their operating procedures. From the perspective of institutional evolutions, these two opposing views have quite different implications. If Friedman is correct, and central banks lose their ability to conduct monetary policy – because there is no longer any ‘money’ – then issues of institutional design to affect monetary policy are clearly no longer of importance. There will be no need for institutions to conduct monetary policy. If Woodford is correct, then monetary policy will remain feasible, and only relatively minor changes in operating procedures will be required. Evolution of the payments system is unlikely to alter the fundamental objectives of monetary policy, just the instrument rules needed to achieve them. For a central bank granted instrument independence, no institutional change is required. Since the contracting approach emphasizes the role of institutional design in defining the goals of the central bank, leaving the central bank free to employ its instruments to achieve these goals, alterations in the linkages between instruments and goals do not require any change in the structure of the central bank, as long as it has adequate powers (such as the power to pay interest on reserves). In Section II of this paper, I discuss the notion that independence is sufficient, and that once insulated from direct political influence, a central bank will deliver a rational monetary policy. Since I conclude that independence is not sufficient, that central bank objectives and incentives need to be carefully designed to ensure optimal policy outcomes, Section III looks at the mapping from incentives to institutions. What mechanisms can be used to implement an optimal contract? Both Sections II and III presuppose that institutional design can serve as a commitment mechanism. Section IV examines the argument that institutions are not commitment mechanisms – if a central bank cannot commit to an optimal policy, how can a government commit to imposing the right incentive structure? This question gets at the heart of whether incentive arrangements are sustainable. Section V offers a brief summary. © Blackwell Publishers Ltd. 2000
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II. Are Optimal Incentives Necessary? Now that many economies have enjoyed low rates of inflation for several years, there seems to be a growing feeling that the time inconsistency literature was overblown, that central banks can be trusted to do the right thing, and that all that is needed is to make sure they understand the natural rate hypothesis and enjoy political independence. It has become standard to specify the objective function of the central bank as depending on inflation variability and the variability of output around the natural rate – on the output gap – thus eliminating the basic source – an overly ambitious output target – of the inflation bias in the Barro–Gordon framework. Blinder (1999), for example, argues that the Federal Reserve does not try to stimulate the economy above the natural rate and so there is no inherent inflation bias. With central banks today painfully aware of the natural rate hypothesis, so the argument goes, there is no reason to be concerned with central bank incentives – maximizing social welfare under discretion will lead to the commitment solution. Even if we ignore the thorny measurement issues involved in actually measuring the output gap, there are several reasons that this argument paints a picture of policy under discretion that is too optimistic. I will briefly mention two. First, Woodford (1999b) has shown that discretion remains sub-optimal if shocks are serially correlated and expectations are forward looking even if the central bank does correctly target the natural rate of output; see also Clarida et al. (1999). Under discretion, the central bank treats expectations as given. Under commitment, the central bank can influence expectations. This critical difference offers an improved output–inflation trade-off under commitment. By committing to reduce future inflation, for instance, a given reduction in current inflation can be achieved with smaller output loss. Targeting the natural rate of output is not sufficient alone to ensure optimal policy responses to economic disturbances. It follows that an average inflation bias is not the only distinction between the discretion and commitment outcomes, a point emphasized by Woodford (1999c). A stabilization bias may also be present, in the sense that the central bank responds to shocks inefficiently under discretion. Second, independence is never absolute. Even independent central banks that target the natural rate may be subject to political pressures. In the ‘active fiscal-passive monetary policy’ model of Drazen (2000), for example, the central bank has a lower output target than the electorate. However, political pressure by opportunistic officials can distort policy. Woolley (1995) has documented the pressures which the Nixon administration brought to bear on the Federal Reserve in 1972. Another example of the pressures brought to bear on the Federal Reserve is provided by the early 1980s when high real interest rates led several members of Congress to propose revising the Federal © Blackwell Publishers Ltd. 2000
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Reserve’s charter to require it to target low real interest rates. In practice, a high degree of central bank independence cannot completely remove a central bank from the political environment within which it must act (Posen 1993). Simply ensuring the central bank focuses on the correct measure of the output gap is therefore not sufficient to ensure optimal policy outcomes. Despite this, the view that central bankers can simply be trusted to do the right thing is implicit in recent work on deriving optimal policy rules. These policy rules are based on the assumption that a central bank can credibly choose to commit to a rule. However, policy rules that central banks follow are endogenous outcomes of the central bank’s decision problem (King 1985, Sargent 1999). That is one reason Milton Friedman’s proposal that the Federal Reserve maintain a constant rate of money growth – the classic example of a policy rule – was not a practical policy prescription. If the Federal Reserve had failed to adopt such a rule in the past, why would it stick to it in the future unless its incentives or perceived constraints were altered? And there is widespread agreement that central bankers in most countries did not do the right thing in the 1960s and 1970s. So even though they may have done the right thing in the 1990s, what assurance is there that sensible monetary policies will continue? Independence and a commitment to the natural rate are not enough – the correct incentives do need to be established to ensure continuation of a ‘rational monetary policy’.
III. Can Optimal Incentives be Implemented? If policy-making institutions matter for policy outcomes, and society needs to align the incentives of policy makers with desired outcomes, how should central banks be designed? What is the optimal contract for a central bank? While a principal–agent perspective provides a means of analysing the optimal incentive structure for a central bank, these incentives must be translated into institutional structures. If a basic level of instrument independence is assumed, should a central bank simply be told to maximize social welfare? Since at least Rogoff (1985), monetary economists have focused on how central banks might be assigned objectives that differ systematically from those of society at large. At one level, the notion that an agency is told to do something other than maximize social welfare is not surprising or unusual. Specialization is the norm – social welfare depends on a whole list of attributes (health, education, etc.) that central banks are not held responsible for, nor are they given the tools to deal with them. We do not ask central banks to maximize social welfare. © Blackwell Publishers Ltd. 2000
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If central banks are not told to maximize social welfare, what should they be told to do? A large literature has addressed this question. Svensson (1999) argues ‘that there is considerable agreement among academics and central bankers that the appropriate loss function both involves stabilizing inflation around an inflation target and stabilizing the real economy, represented by the output gap’. Such a loss function forms a key component of ‘The Science of Monetary Policy’ (Clarida et al. 1999). Woodford (1999a) has shown how such a loss function can be derived as an approximation to the utility of the representative agent. Based on this view, instrument rules are derived that are designed to minimize this loss function. Perhaps one reason for this broad agreement about the loss function is that it places almost no constraint on policy. The reason is that, except in some special cases,1 the policy that is optimal under such a loss function depends in a critical way on the relative weight placed on the two stabilization objectives. And this weight is a free parameter in most of the recent literature on policy rules. Telling an independent central bank that it should credibly commit to a policy rule that minimizes a loss function allows the central bank to supply its own value for this weight. There is a large literature that has examined the connection between the implicit weight in the central bank’s loss function and the ‘true’ weight in a social loss function. Much of this literature can be interpreted from a contracting point of view, since its objective is to determine how the incentives of the central bank might differ from those of society. Rogoff ’s classic paper (Rogoff 1985) showed that the central bank should weigh inflation more heavily than society. Because this weight (the degree of conservatism) can also be interpreted in terms of a quadratic penalty imposed on the central bank for inflation target misses, it provides a link with the contracting approach. In Walsh (1995a), the notation of a wage contract offered to the central bank was interpreted as a fictional device that provided a convenient structure for solving for optimal incentives in which an explicit payment was made to the central bank on the basis of observed outcomes. This allowed one to derive the optimal incentive structure. The more difficult problem lies in mapping the optimal incentive structure into actual institutional details.
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One special case that has received a great deal of attention arises when prices are sticky but nominal wages are completely flexible. Optimal policy in this case involves stabilizing the price level, independent of the relative weight on output and inflation stabilization (Woodford 1999b, King and Wolman 1999, Erceg et al. 1999).
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A. Mapping Incentives into Institutions The contracting approach focuses on deriving the optimal incentives. How do these translate into specific aspects of the institutional design of a central bank? Several concrete aspects of a central bank’s structure can be linked to incentive structures – targeting rules, appointment procedures, term lengths, dismissal rules and announcement requirements. In the basic Barro–Gordon model, augmented to incorporate a role for stabilization policy and for the possibility that the central bank possessed unverifiable private information, the optimal contract turned out to relate the central banker’s incentives linearly to the rate of inflation (Persson and Tabellini 1993, Walsh 1995a). The basic intuition behind this result was that it raised the marginal cost of inflation – as perceived by the central bank – and therefore resulted in a lower average rate of inflation. Since the distortion under discretion in the Barro–Gordon model was constant across states of nature, the marginal cost of inflation only needed to be increased by a constant amount that was itself state-independent. The attention that linear inflation contracts attracted was reinforced by Svensson’s demonstration that they were equivalent to the assignment of an inflation target to the central bank (Svensson 1997). This result provided a theoretical rationale for inflation targeting as a means of ensuring that central banks, operating under discretion, faced the correct incentives. In many models, however, the distortion created by discretion is not independent of the state. As discussed earlier, even in the absence of an average inflation bias, discretion may fail to achieve optimal policy outcomes. In this case, the optimal contract will no longer be linearly related to inflation. As a number of authors have shown – e.g. Lockwood and Herrendorf (1997) and Beetsma and Jensen (1999), contracts that involve both linear and quadratic terms in inflation can lead to improved policy outcomes. The quadratic term serves the same role as conservatism does in Rogoff (1985), increasing the weight the central bank places on achieving its inflation target, and thus corresponds to a flexible inflation targeting regime. Walsh (2000) shows how the optimal weight to place on achieving the target depends on the degree of transparency – where transparency is interpreted as the ability of the public to monitor central bank policy.2 When transparency is perfect, a strict inflation targeting regime is optimal. Under such a regime, the central bank is instructed to focus solely on achieving its inflation target and is held accountable for achieving the target. 2
Thus, policy is transparent when the public is able to monitor what the central bank should do. Cukierman and Meltzer (1986) and Faust and Svensson (2000) interpret transparency in terms of the ability of the public to monitor what the central bank intended to do.
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Appointment procedures, term lengths and dismissal rules are all aspects of the central bank’s design that are typically ignored in the analysis of policy rules. The theoretical literature has stressed the role these aspects can play in enforcing accountability over policy and in ensuring that central bank policy is responsive to changes in public preferences. Waller and Walsh (1996) analyse optimal term lengths and their interaction with partisanship in the appointment process and central bank conservatism. Walsh (1995b) shows that any average inflation bias can be eliminated if the central bank is dismissed whenever inflation exceeds a critical threshold. The New Zealand’s Reserve Bank Act includes such a possibility. In the presence of a state-contingent inflation bias (a situation in which the inflation contract would need to be state-contingent), a dismissal rule based on a modified nominal income targeting rule can support optimal incentives. Muscatelli (1998) and Walsh (1999) show how central bank incentives are influenced if the central bank has private information on the state of the economy and is required to announce a target for inflation. By announcing its own inflation target, the central bank partially reveals its private information about the economy. If it is then held accountable under a flexible inflation targeting policy, the announcement allows for an optimal stabilization response to supply shocks. These examples illustrate how concrete aspects of a central bank’s structure have been analysed in ways that help us to understand how institutional details serve to shape policy outcomes.
IV. Are Institutional and Policy Changes Sustainable? In recent years, several central banks have adopted inflation targeting as a framework for formulating monetary policy. In some cases, though, elected governments imposed the inflation targets. In other cases, the central bank itself established them. In either case, are these and other policy changes sustainable? Have recent central banking reforms provided lasting solutions to the problem of ensuring a rational monetary policy? In addressing the sustainability of recent reforms, it is useful to distinguish between reforms enshrined in the legal charter of the central bank and reforms that reflect changes either negotiated between an elected government and the central bank or established unilaterally by the central bank.
A. Formal Institutional Changes Changes in formal institutions represent a ‘change in the rules’ of a wellspecified political game (Myerson 2000). Reforms that are embedded into © Blackwell Publishers Ltd. 2000
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legal charters or in the actual establishment of new institutions such as the ECB are costly to change. A president who wishes to pressure the Federal Reserve to change policy would find it very difficult to go about it by making Congress alter the Federal Reserve’s charter. Even a president with popular backing is likely to find this route difficult to pursue, just as Franklin Roosevelt’s attempt to increase the size of the Supreme Court proved unsuccessful. Changes in legal charters are often subject to supermajority voting in the legislative body. Even when such a majority exists in favour of a specific change, the process of revising a legal charter may offer an opportunity for many other potential changes to be proposed – it can be difficult to ensure that only the desired revision is incorporated. As a result, changes in formal institutional structures are rare. Because the basic structure of a policy-making institution is costly to change, the legal design of a central bank does affect policy outcomes by altering the rules of the game played out among the participants. Formal institutions do represent commitment devices. While the rules of the game may be difficult to change, committing to an institutional structure, one that grants great independence to a central bank for example, is not the same as a mechanism that would allow the central bank to credibly commit to an optimal policy. Dixit (1999), for instance, shows how the central bank in a monetary union must take into account the incentive compatibility constraints of the member countries. Even though it is costly for an individual country to withdraw from the union, the central bank may need to shift policy away from the commitment solution and towards the discretionary outcome to ensure the continuing support of all members.
B. Policy Procedures as Commitment Devices Many recent reforms do not represent the type of binding commitment associated with the establishment of a new institution or the revision of a legal charter. A government may assign an inflation target to the central bank, but it may turn a blind eye towards target misses if such misses are ex post optimal. A central bank that sets its own target for inflation may easily revise it. A transparent central bank may become more opaque in subtle ways. Policy reforms are sustainable if they satisfy an incentive constraint – the central bank (government) must be better off adhering to the policy than if it deviates. Many of the discussions of the recent reforms (such as the implementation of transparent inflation targeting regimes) simply assume that these policies are incentive compatible. Promising and delivering low inflation, for example, alters expectations. If the central bank adheres to a low inflation policy, the public’s expectations about future inflation are lowered, making continuation of low inflation the optimal policy choice of the central bank. © Blackwell Publishers Ltd. 2000
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Sargent (1999) highlights a contrast in the treatment of expectations that is relevant for considering many of the recent changes in central bank policy procedures. One view of policy is that there exists a multiplicity of equilibria indexed by expectations, and policy makers can manipulate expectations. In this view, policy makers can select a good equilibrium through suitable manipulation of the public’s expectations. Sargent characterizes the rational expectations revolution of the 1970s as eliminating both multiplicity and manipulation – with policy taken as exogenous, there was only one set of beliefs consistent with both rational expectations and the given policy. Finally, recent work on credible policies provides support for the notion that there can exist a multiplicity of equilibria, but the government cannot manipulate expectations. Instead, the government ‘conforms’ to expectations, in Sargent’s words. The multiplicity of equilibria means that a wide range of outcomes is possible in the sense that many policies may be credible and sustainable. These might include an optimal policy rule, an equilibrium in which a government sets an inflation target and refrains from overriding the central bank, and one in which the central bank announces and delivers a target rate of inflation. Distorted stabilization and high inflation might also be a sustainable equilibrium. In all cases, the sustainability of a policy regime depends critically on the costs to the central bank of deviating to pursue short-run gains. This last point is critical. Conclusions about the sustainability of any policy regime will depend on what we assume happens if the central bank deviates from the policy it has promised to follow. It is not sufficient to just tell central banks to commit to an optimal policy rule – whether such a policy can be sustained will depend on the public’s perception of the cost to the central bank of a deviation and that, in turn, depends on the equilibrium achieved after a deviation. With this in mind, how sustainable are recent reforms? If, as seems reasonable, the costs of deviating will be larger, or at least more immediate, when the public can easily observe any deviations, then commitments to public inflation targets (by either the government or the central bank) are more likely to help sustain a low inflation policy than would less publicly made promises. In New Zealand, for example, changes in the inflation agreement between the Reserve Bank and the government must be tabled in Parliament. This public process makes it more costly for the government to alter its instructions to the central bank. Central banks that issue inflation reports would find it hard to halt their publication, and this is one reason Faust and Svensson (2000) argue that central banks are able to commit to a degree of transparency. Aspects of a policy process that are hidden from public view are less likely to be credible – the inability of the public to discover a deviation will make them less likely to find the process credible. © Blackwell Publishers Ltd. 2000
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More problematic are proposals for central banks simply to credibly follow optimal policy rules (Svensson and Woodford 1999). These involve responding to macroeconomic variables such as inflation and the output gap, and adherence to the promised rule would be difficult to monitor. The public would need to know the central bank’s estimate of the output gap, for instance, and this would be hard to verify. While most proposals for central banks to follow rules also call for transparent processes in which the bank would explain its policy actions with reference to the rule, the ability of the public to fully monitor the central bank’s actions may be limited. The distinction between reforms that are formalized in legal charters and those that reflect less formally binding commitments is easily exaggerated, however. As Dixit (1996, p. 25) puts it: Individual policy acts that are made within a given set of rules may seem easy to reverse within the same framework, but they often create facts, institutions, and expectations that have their own momentum and acquire at least some of the same durability as a change in the constitution itself.
V. Summary In this paper, I argued three points. First, central bank independence with a loss function based on the output gap is not sufficient to ensure that discretion delivers optimal policy. While it may eliminate the average inflation bias that was the central focus of the time inconsistency literature, independence does not guarantee that the optimal trade-off between inflation volatility and volatility in real economic activity will be achieved. It is also not a sufficient guide to policy – trade-offs depend on the relative weights placed on output and inflation variability. There is no a priori reason to expect an independent central bank to be better at judging what that weight should be than elected politicians. In fact, a basic principle of democracy is that the opposite is more likely. Second, the notion that the central bank is assigned an objective that differs systematically from that of society’s is well established, and the effects on policy outcomes of a variety of practical aspects of institutional design have been investigated in the literature. Studying how policy decisions are influenced by appointment procedures or reporting requirements, or deriving optimal incentive structures is of interest only if one adopts the view that central banks are optimizing agents. The alternative view is that central banks are able to commit to simple rules if they only choose to do so. Finally, recent reforms have differed in the degree to which they are based on formal and legal institutional changes or are based on operational changes © Blackwell Publishers Ltd. 2000
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in policy procedures. Formal institutions do matter. They alter the rules of the game. Because they are costly to change, and such changes are public, they do serve as commitment mechanisms. They are not perfect in this regard – what societies establish, they can also change. The sustainability of less formal policy changes such as publicly announced inflation targets or commitments to transparent policy processes are harder to judge. Their credibility depends critically on the equilibrium should the central bank fail to conform to the public’s expectations. However, policies under which the public easily observes deviations – transparent policy regimes – are more likely to be sustainable. Carl E. Walsh Department of Economics University of California Santa Cruz, CA 95060, USA
[email protected] and Federal Reserve Bank of San Francisco
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