Overcoming the Inflationary Bias Through Institutional Changes - Experiences of Selected OECD Central Banks

Schich, Sebastian; Seitz, Franz Article Overcoming the Inflationary Bias Through Institutional Changes - Experiences of Selected OECD Central Banks Schmollers Jahrbuch – Zeitschrift für Wirtschaftsund Sozialwissenschaften. Journal of Applied Social Science Studies Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Schich, Sebastian; Seitz, Franz (2000) : Overcoming the Inflationary Bias Through Institutional Changes - Experiences of Selected OECD Central Banks, Schmollers Jahrbuch – Zeitschrift für Wirtschaftsund Sozialwissenschaften. Journal of Applied Social Science Studies, ISSN 1865-5742, Duncker & Humblot, Berlin, Vol. 120, Iss. 1, pp. 1-24, https://doi.org/10.3790/schm.120.1.1 This Version is available at: https://hdl.handle.net/10419/291947 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Schmollers Jahrbuch 120 (2000), 1-24 Duncker & Humblot, Berlin Overcoming the Inflationary Bias Through Institutional Changes - Experiences of Selected OECD Central Banks* By Sebastian Schich and Franz Seitz Abstract The paper analyses the institutional changes that have taken place during the 1990s at the central banks of major OECD countries. They have generally resulted in an increased degree of independence, transparency and accountability as well as in mandates more narrowly focused on the achieving and maintaining of price stability It is argued that recent theoretical and empirical research on the institutional aspects of monetary policy are useful in interpreting these changes. The implications for the design of the European Central Bank are discussed against the background of this research and the experiences with the recent changes at national central banks. Zusammenfassung Wir analysieren die institutionellen Änderungen, die sich in den Zentralbanken der OECD-Lander in den 90er Jahren ergeben haben. Generell resultierten diese in einer erhöhten Unabhängigkeit, Transparenz und Rechenschaftspflicht sowie der Spezifikation der Gewährleistung von Preisstabilität als Hauptaufgabe der Zentralbanken. Das Papier arbeitet heraus, dass theoretische und empirische Untersuchungen zu den institutionellen Aspekten der Geldpolitik hilfreich sind, diese Änderungen zu erklären. Vor diesem Hintergrund und den Erfahrungen der nationalen Zentralbanken werden abschließend die Implikationen für die Europäische Zentralbank diskutiert. JEL Classification: E5 1. Introduction Central banking in the last two decades has been largely influenced by two developments. First, the emergence of stagflation in the early 1970s. This gradually lead most economists and policymakers to conclude that * This paper has benefited from comments by J. Elmeskov, M. Feiner and M. Kennedy of the OECD's Economics Department and 2 anonymous referees. The paper does not necessarily reflect the opinion of the OECD's Economics Department, and the authors are solely responsible for any errors. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 2 Sebastian Schich and Franz Seitz there is no long-run trade-off between inflation and unemployment. Concentrating on the primary goal of price stability was recognised the best way monetary policy could contribute to good economic performance over time. Second, the transformation of the financial sector which gathered momentum in the 1980s as a result of liberalisation and financial innovation, increased the mobility of capital and the sanctioning power of financial markets. This meant that market participants' concerns about the stance of monetary policy and their (mis-)readings of the objectives of individual central banks became more easily and quickly translated in interest rate or exchange rate premia for the currencies of the countries concerned. Against this background, central banking has changed in several ways. The search for reliable external or internal nominal anchors became more difficult. On the one hand, exchange rate commitments became harder to sustain. On the other hand, the usefulness of the most popular anchors adopted in the 1970s, i.e. monetary aggregates, was gradually eroded in most countries. The responses included a reorientation of the monetary policy strategy, in some cases to a direct inflation targeting strategy (e. g. the Bank of England or the Reserve Bank of New Zealand), in others to a more flexible and pragmatic orientation of monetary policy (e. g. the Deutsche Bundesbank or the Fed). Furthermore, and maybe more fundamentally, the institutional designs of many central banks have been changed. These changes have resulted in an increased degree of independence, a more focused mandate on achieving and maintaining price stability, an increased degree of accountability and of transparency about objectives, strategies, the actual decision-making process and the intentions regarding short-term monetary policy implementation. The present paper has two purposes. First, it describes the institutional changes that have occurred during the 1990s at the central banks of major OECD countries (for an overview see table 1). In this context, special emphasis is laid on the implications for the European Central Bank (ECB) and the Eurosystem. For this new institution these insights are important because it has no established track record. Second, the paper interprets these changes against the background of the recent theoretical and empirical literature on the institutional design of central banks.1 It argues that this literature is useful in interpreting the reasons and consequences of the institutional changes that have occurred in practice. Although the changes that have taken place at central banks in developed countries is the focus of the descriptive analysis, the discussion of the underlying rationale is potentially of interest to central banks from developing and transformation countries 1 For more formal oriented surveys on the institutional design of central banks see Persson/Tabellini (1999) and Prast (1996). Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 3 Table 1 Recent changes of institutional structures of central banks in selected OECD member countries Country Year Summary of changes3 Canada 1991 (t) formal inflation target.b France 1994 (0) price stability as explicit objective; (1) instrument and goal independence; (i) government cannot give instructions to the Banque de France. Italy 1992 (i) terminating the automatic extension of central bank credit to the government. Japan 1997 (0) price stability as explicit objective; (1) independence of the Bank of Japan in formulating and implementing monetary policy; (i) assignment of the decision making in monetary policy to a single body - the Policy Board - in which government representatives have no vote; government influence on choice of Policy Board members reduced; (i) Board members cannot be dismissed in cases of conflict with government; (t) minutes and records of the Policy Board meetings will be publicly disclosed. (t) every six months the Bank must report on its activities to the Diet. Sweden 1989 (i) reduction of political influence on appointment of Governor; (i) lengthening of the Governor's term of office. 1993 (t) formal inflation target is specified by the Bank of Sweden;5 (t) inflation report. 1998 (o) explicitly lays down price stability as objective of monetary policy; (0) some responsibility for exchange rate regime transferred to government; the government will have authority to decide, after consultation with the Riksbank, on the choice of the exchange rate regime. The Riksbank has the responsibility for the implementation of the exchange rate system adopted by the government; (1) the Bank is no longer required to consult but only to inform the government on important monetary policy decisions; (i) Governor cannot be dismissed in cases of conflict with government. United Kingdom 1992 (t) inflation target set by Chancellor of the Exchequer and Bank of England (BoE)b; (i,t) BoE produces independent assessment of progress in meeting inflation targets. 1993 (i) Bank of England is given discretion over timing of changes in interest rates. 1994 (i,t) publication of the minutes of the meetings between the Bank of England and the Chancellor in which the former gives its independent advice to the latter. 1997 (i) Bank of England is given authority over the setting of interest rates; (i) policy decisions are made by a new Monetary Policy Committee (MPC), the members of which will be appointed by the Governor and the Chancellor; a representative of the Treasury will attend the meetings of the MPC, but has no vote; (i) government cannot give instructions to the new committee; (o) responsibility for banking supervision will be transferred to a separate institution; (o) responsibility for debt management transferred to the Treasury. a) Changes affecting the objectives, the degree of independence and transparency are identified by (o), (i) and (t) respectively. When an institutional change had implications for more than one of these aspects, an additional identifying character is included. For example, in October 1992 the Chancellor of the Exchequer asked the Bank of England to produce an independent assessment of progress in meeting the inflation targets (resulting in the publishing of the Inflation Report). This measure increased the Bank of England's independence and its transparency, thus identification (i,t). b) The adoption of formal inflation targets is obviously in the first instance a choice regarding strategies. But the fact that, in practice, it has been associated with an increase in transparency, suggests to categorise it under the measures increasing transparency. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 4 Sebastian Schich and Franz Seitz as well (see e. g. the current discussions in India, South Africa, Estonia and Bulgaria). This holds in particular as many developing countries have used the Fed or the Bundesbank as benchmark models. The paper proceeds as follows. Section 2 explains the fundamental problem of the inflation bias inherent in non rule based monetary policy. Against this background, the remainder of the paper distinguishes between four dimensions of the institutional structure of central banks that are relevant for this bias. Section 3 discusses the changes to explicit mandates, section 4 to the degree of independence and section 5 to the degree of accountability of such institutions. And section 6 explains the changes towards more transparency about objectives, strategies and the actual decisionmaking process. While all these measures were motivated by a response to the time-inconsistency problem, the increase in transparency was also driven by a perceived need to provide clearer signals of central bank intentions and to avoid mis-readings of its policy by an internationally diverse group of market participants (BIS, 1997). Section 7 then draws some lessons for the ECB. Finally, section 8 concludes and summarises. 2. The 'inflation bias' in discretionary monetary policy The fundamental problem of discretionary policy, i.e. a policy that is not based on rules, arises as a consequence of (monetary) policymakers' incentive to deviate ex post from ex ante announcements and to create surprise inflation to modify the real value of nominal contracts, for example to achieve short-term employment gains.2 Rational agents are aware of that incentive and pre-emptively ask for higher wages to secure the desired real wage. To avoid depressing economic activity, the policymaker then has to accommodate these price expectations and create the anticipated inflation. Finally, there are no employment gains but only the additional costs in terms of higher inflation. This is inefficient because society bears the costs of higher inflation without the benefits of even a temporary increase in employment following surprise inflation. 2 See e. g. Kydland/Prescott (1977) and Barro/Gordon (1983). The relevance of this, however, has also been questioned. For example, Blinder (1997) argues that it is a purely theoretical phenomenon because modern central bankers never try to cheat the private sector. Their only objective is achieving price stability or controlling inflation. Furthermore, McCallum (1997) claims that it is inappropriate to presume that central banks will, in the absence of any tangible precommitment technology, inevitably behave in a discretionary fashion that implies an inflationary bias and that there is no necessary trade-off between flexibility and commitment. And Romer/Romer (1997) argue that limited knowledge about how the economy operates and the effects of monetary policy has been a much more pervasive obstacle to good policy than dynamic inconsistency. On the other hand, Ireland (1999) empirically validates the long-run implications of the time-consistency problem for inflation in the US. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 5 Besides an underlying desire for employment gains the inflation bias could reflect a number of different aspects, such as larger seigniorage revenues (Klein/Neumann, 1990, de Grauwe, 1996) or a concern about financial stability (Mankiw et al., 1987, Cukierman, 1990).3 In practise, the seigniorage motive seems to be only of minor relevance in OECD countries because relatively efficient tax systems are generally available for tax collection (White, 1999). Also, financial problems of banks, with the notable exception of some Asian countries during the recent financial crisis, seemed to have been mainly the result of idiosyncratic shocks - which the central bank cannot noticeably influence through the creation of additional liquidity for the whole banking sector. Furthermore, most episodes of financial instability occurred during disinflationary periods that followed those of sustained inflation (Bordo/Wheelock, 1998). This suggests that control of inflation could enhance, rather than interfere with the stability of the financial system. Thus, the concern about employment gains does appear to be the most relevant motive for surprise inflation in actual practice (Walsh, 1998, ch. 8).4 In principle, reputation could reduce the inflation bias when the time horizons of the central bank and the public are infinite. A reputational equilibrium with low inflation can be sustained by the threat that the public will 'punish' the central bank for surprise inflation with periods of high inflation expectations (Barro / Gordon, 1983). This points to the role the public plays in supporting a credible and stability-oriented monetary policy. If the public is decidedly averse to inflation, it is difficult for monetary policy to break inflationary expectations after a surprise inflation. This would make the subsequent process of disinflation more costly and thereby effectively discourage monetary policy-makers from using the means of surprise inflation in the first place. 3. Narrowing the mandates One important institutional change has been the narrowing of central banks' mandates to achieving and maintaining price stability. As can be 3 The Maastricht Treaty explicitly mentions that one of the basic tasks of the European System of Central Banks (ESCB) is promoting the smooth operation of the payments system. To that extent, one could argue, the ESCB should share a concern for financial institutions' stability. 4 A new reason why monetary policy may be subject to a persistent inflationary bias was introduced by Kasa (1999). He shows that when a central bank must balance optimisation and learning and recognises that its current actions influence its future beliefs, there is no guarantee that it will discover the true nature of the (exogenous) data-generating process of the economy. This may lead the central bank to believe that there is an exploitable relationship between inflation and unemployment, even when no such relationship exists. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 6 Sebastian Schich and Franz Seitz seen from table 1 several countries have gone in this direction in the 1990s. Canada, Sweden and the UK adopted an inflation targeting regime, and France and Japan changed their central bank laws to incorporate price stability as the final objective of monetary policy. This goes hand in hand with the fact that explicit targets for monetary policy have become more widely used in the 1990s than at any time since the Bretton Woods era in industrial as well as in transitional and developing countries (Sterne, 1999). The narrowing of mandates to achieving and maintaining price stability was achieved through a more explicit specification of price stability as the final objective of monetary policy. In the case of the adjustment requirements implied by the Maastricht Treaty price stability has to be specified as the primary and overriding goal of monetary policy of EU central banks.5 Examples are the legal regimes of the Banque de France and the Banco de España which have been amended to set price stability as the primary objective of monetary policy. These amendments took effect on January 1994 and June 1994. In September 1995 a new law redefined the primary objective of the Banco de Portugal to maintaining price stability. Although there are still no explicit statutory objectives in the field of monetary policy in the UK, in May 1997 the Chancellor announced that the Bank of England will have a specific monetary policy objective of delivering price stability. In the case of Sweden, maintaining price stability has become the prevailing objective of monetary policy in 1998. Another way of narrowing the mandates to achieving and maintaining price stability consisted of the transfer of other responsibilities to different institutions altogether. For example, the objectives of maintaining price stability and financial stability may conflict with each other. Thus, the separation of the two responsibilities may imply a smaller incentive for the central bank to use monetary policy to ensure financial stability. This, in turn, could reduce the moral hazard problem commercial banks are faced with. Recently, the transfer of responsibility for financial stability from the central bank to another institution has been decided in the case of the Bank of England and discussed in the case of the Banque de France. The ECB has no supervisory responsibilities, too. Although there are still central banks that act as supervisory agencies (see table 2), the general trend seems to be towards a separation of the monetary and the supervisory function (Goodhart / Schoenmaker, 1995).6 An important aspect of these institutional changes is that the allocation of relative responsibilities of monetary, fiscal and other authorities within 5 This is also true for the countries applying for membership in the EU. 6 An exception is Finland. Although the monetary and supervisory responsibilities are officially still separated, de facto there has been a move towards combining the two as a reaction to the domestic banking crisis. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 7 Table 2 Central banks acting as supervisory agency yes no France United States Australia Italy Japan2 Germany Greece Ireland Luxembourg Netherlands New Zealand Portugal Spain United Kingdom1 Canada Austria Belgium Denmark Finland Norway Sweden Switzerland 1. The responsibility for banking supervision was transferred to a new institution in 1998. 2. Although the Bank of Japan has no official supervisory function it shares some responsibility for financial stability through its mandate to ensure stability of the payment system. 3. Although in a legal/administrative sense, the Financial Supervision Authority is part of the Bank of Finland, in its actual supervisory work, i.e. in performing its own statutory duties, the Financial Supervision Authority acts as an independent administrative unit exercising public authority. Source: Goodhart / Schoenmaker (1995), Bank of Finland (1996). the general macroeconomic and regulatory policy mix become more clearly defined. Assigning each institution a responsibility for which it is well-suited is a precondition for holding it accountable. Otherwise the monetary, fiscal and regulatory outcomes cannot easily be attributed to the actions of the individual institutions. An explicit (and narrow) mandate for price stability makes it clear, especially for the public, that inflation is ultimately a monetary phenomenon and that the responsibility lies with that institution which has been delegated the responsibility to control the money supply. Laying down price stability as an explicit goal, especially when specified as the primary and overriding goal, strengthens the position of the central bank. This is especially true in situations of conflict when pressure groups want the central bank to put more emphasis on other objectives, such as reducing unemployment. Of course, this does not mean that the objective of achieving and maintaining price stability should be interpreted as the sole objective of monetary policy. Even when the objectives of monetary policy are defined relatively narrowly, the need for consistency of monetary policy with other macroeconomic policies is generally recognised. But it has to be clear to the public that price stability is the overriding objective. Provided Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 8 Sebastian Schich and Franz Seitz the public is aware of a change in emphasis towards the maintaining of price stability and is convinced that it will not be easily reversed, it could help to attenuate the "inflation bias". 4. Augmenting independence Rogoff (1985) suggested that delegating the responsibility for monetary policy to a conservative central banker, i.e. one that has a higher inflation aversion than society as a whole, could attenuate the inflation bias at only little costs in terms of higher output variability. This model comes closest to the general perception of independence: delegation of monetary policy to an inflation-averse central banker which can make independent use of its instruments. The interesting aspect is that when the degree of conservatism is chosen optimally, the central banker secures a welfare outcome that Pareto dominates both the case of discretion and of rules. Specifically, the central banker does not sacrifice too much flexibility in exchange for additional credibility. Using cross-section data, Alesina/ Summers (1993) claim that countries with more independent central banks not only enjoy lower inflation without having to sacrifice growth, but also do not experience greater output variability.7 In a later paper, Alesina / Gatti (1995) provide a theoretical rationale for this result. Even though the "conservative" central bank is less concerned about the stabilisation of exogenous output shocks (the original argument of Rogoff, 1985), being remote from the political sphere, it creates less policy-induced shocks. Thus, taken by itself, increasing the independence of central banks provides a 'free lunch' in the sense that average inflation is reduced with no costs in terms of higher output variability.8 7 Temple (1998) shows that the negative relationship between inflation and central bank independence vanishes for high inflation countries from the developing world. One reason for this might be that in these countries measures of central bank independence are no good indicators of institutional credibility. Campillo / Miron (1997) argue that institutional arrangements do not by themselves be of much help in achieving low inflation. Economic fundamentals such as openness, political instability, and tax policy seem to play a much larger role for developed as well as for developing countries. For a discussion of the relationship between central bank independence and inflation performance see also the special issue in the Oxford Economic Papers (1998). 8 This is in contrast to Walsh (1995b) who shows that an increased focus on inflation objectives by the central bank can raise the degree of nominal wage rigidity (and thus lead to a flatter short-run Phillips curve) by inducing less nominal wage indexation. But if one interprets independence and conservatism as being associated with a lower target for inflation rather than a greater weight on inflation objectives, increased independence will lower average inflation without leading to an increase in the variability of output (Svensson, 2000). Tambakis (1999) derives a threshold for the initial degree of effective central bank independence below which the absolute change in inflation variability following a change in central bank independence exceeds that in output variability. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 15 lie."14 Indeed, although there was no legal requirement in the Bundesbank Act or in later legislation for the Bundesbank to give a formal account of its policy to any public body, except that it may at its discretion publish the monetary and banking statistics that it collects, the Bundesbank has traditionally been making heavy use of this opportunity. This was not designed to give any detailed information about the preferences of the Bundesbank. It aimed more to give a rapid feedback about the state of monetary conditions so that general policy uncertainty was reduced. These explanations were extremely important in phases of important monetary policy challenges, such as the German unification and the EMS crises in the 1990s which were characterised by an increase in the number of speeches held by Bundesbank officials. The move towards greater transparency has been even more widespread as regards the day-to-day implementation of policies (Borio, 1997, ch. 5). Several central banks have shifted to more explicitly signalling their intentions about the desired interest rate levels, e. g. through the choice of fixed rate tenders. For example, from the beginning of 1996 to the end of 1998 the Bundesbank, used only this tender. And the ECB exclusively applied fixed rate tenders for its main refinancing operations until June 2000. These examples have to be seen against the background of the rapid internationalisation of financial markets which has brought central banks under increased scrutiny of an internationally wider and more diverse group of market participants. The latter are often less familiar with the interpretation of statements and policy measures of individual central banks, thus increasing the probability of misinterpretations. Moreover, the actors on financial markets have the capacity to initiate large and rapid capital movements resulting in large fluctuations in interest rates and exchange rates. This has been recognised by central banks. For example, when the Federal Open Market Committee decided at its first meeting of 1994, to announce the short-term policy decision promptly after the meeting, it stated that the purpose of the announcement was to "avoid any misinterpretations of the Federal Open Market Committees' actions and its purpose" (Pakko, 1995). Traditionally, secrecy has been a distinctive feature of central banking, and something which has always been guarded. The FOMC won a legal case in which public disclosure was at issue, claiming that public disclosure would raise the variability of interest rates and thus the risk premium to compensate for that additional variability. And this in turn would harm the commercial interests of the Treasury (Goodfriend, 1986). The theoretical rationale is well known. Any revelation of more private information - more 14 On the other hand Faust / Svensson (1999) develop a model in which, under commitment, a sufficiently patient central bank with sufficiently low average inflation bias will always choose minimum transparency. Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 16 Sebastian Schich and Franz Seitz "news" - increases the unconditional variance of forward looking asset prices if they are priced rationally and efficiently. However, comparing the (unconditional) variances of interest rates around FOMC meetings before and after the shift to the new immediate disclosure regime de Vijlder/ Valckx (1996) did not find evidence for a significant change. This lends some support to the proposition that the immediate public disclosure does not raise the variability of interest rates (or that no news were revealed in the FOMC meetings). In any case, as Dotsey (1987) pointed out, transparency reduces the conditional variance of interest rates since it increases the information available to agents and thus induces smaller and less frequent forecasting errors. Recent research at the Bank of England seem to confirm this. Haldane/Read (1999) find that bond market interest rates indeed react systematically to changes in the Bank of England official rates. But the magnitude of these reactions has fallen significantly since 1992 when the Bank of England started to increase its transparency. 7. Designing the institutional framework: The example of the ECB While, in principle, all of the theoretical considerations discussed above apply to the ECB as well, the ECB's situation is special in at least two aspects. First, unlike in the case of existing central banks, a reputational equilibrium with price stability was not available when the ECB took up its responsibility for monetary policy in January 1999 because it did not have an own inflation track record. An environment of low inflation and low inflation expectations is an advantage for the ECB. However, for many countries participating in Stage 3 there is simply no or only very recent experience of how the private and public sector behave in an environment of sustained and credible low inflation. Nevertheless, to the extent that the ECB succeeds in being associated with those national central banks that have acquired a good reputation over a long period, it could, at least partly, take over their reputation. This can be seen as one aspect of the rationale behind the adoption of an institutional design that follows closely the example of the Bundesbank. However, this effect will at best be transitory. Second, the ECB is not a national institution but a supranational institution charged with conducting monetary policy for (initially) eleven sovereign countries. This has further implications regarding independence, transparency and accountability. One aspect is the relationship of national wage and fiscal policies with the common monetary policy. Will these policies, still decided at the national level, take into account the new monetary environment characterising the euro area as a whole? Against this backSchmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 17 ground it could be argued that the ECB has to react more flexibly than national central banks in the past to inflationary cost push and fiscal policy shocks due to the uncertainties inherent in the regime shift to EMU and the differences in the financial structure of the 11 Euro countries. Drawing lessons from sections 2-6 for the ECB would be facilitated if there was a unique model of the central bank structure to which all central banks are converging. Two observations can be made in this context. First, the need for major institutional changes seemed to have differed across central banks. In the case of those central banks which had already gained a high degree of reputation there seemed to have been less need for change. Examples are the Bundesbank, the Swiss National Bank and the Federal Reserve. Elsewhere major changes in the institutional structures have occurred (see table 1). Second, the institutional structures of central banks have changed towards a model which is characterised by a high degree of independence, a narrow definition of their mandates and, albeit to a lesser extent, by an increased degree of transparency. By contrast, there does not seem to be a unique model regarding formal accountability and increases therein have been confined to only a few central banks. Has there been an alternative to these changes? Sometimes policy has been changed so that reputation could be built up, e. g. by tolerating a temporary "stabilising recession" to signal that the central bank is more "conservative" and to regain credibility and reputation (Bofinger et al., 1996, 576 ff.). But this solution is very costly in terms of output and employment losses. Another means for the ECB to acquire the necessary reputation may be the choice of the monetary policy strategy. The chosen strategy rests on three elements. The first element ("the anchor") is the quantification of the primary objective of price stability, specifically as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. This clearly states that inflation (increases beyond 2%) and deflation (negative growth rates of the HICP) are incompatible with price stability. The second element of the strategy is the prominent role assigned to money, reflecting the insight that the origins of inflation over the longer term are monetary in nature. For that purpose the ECB announced a reference value for the growth of the broad monetary aggregate M3 of 4 V2 % for 1999 and 2000. The third element is a broadly based assessment of the outlook for price developments and the risks to price stability, using indicators ranging from output gaps to asset prices and business surveys. By placing particular emphasis on monetary aggregates in its monetary policy strategy, the ECB may be able to appropriate some of the reputation acquired by the Bundesbank - which always stressed that inflation is ultimately a monetary phenomenon. However, in supplementing this pillar with the third element the ECB signalled that it recognises the uncertainty facing a common moneSchmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 18 Sebastian Schich and Franz Seitz tary policy. This is especially true for the uncertainties regarding money demand behaviour. Another means to ensure high credibility has been the choice of a large degree of independence. According to table 3 the ECB is one of the most independent central banks in the world. The Eurosystem (the national central banks of the Euro area and the ECB) are independent from both national governments and institutions of the European Union. Its primary task is to maintain price stability, which, however, does not mean that this is the sole objective of monetary policy. But the Maastricht Treaty clearly spells out that the support of the Eurosystem for the general economic policies in the Community must be without prejudice to the objective of price stability. Independence of central banks is not an end in itself but only a means of achieving the objective set by legislature. This implies that the central bank is to be held accountable for its decisions. Even in the absence of formal requirements this means accountability to the general public. For the ECB as a new institution accountability is a prerequisite for establishing credibility and reputation. Especially, it has to disclose and justify the progress it has made in attaining price stability, its monetary strategy and its ongoing monetary policy measures. Furthermore, the Governor of the ECB will present an annual report to the European Parliament and the members of the ECB Executive Board can be called to report before the relevant committees of the European Parliament. The ECB clearly stated that the most important aspect of accountability is the actual inflation track record. To ensure successful policy, it is essential to convey to the public a sense of reasoning behind the decisions of the Governing Council and a coherent summary of the information upon which decisions are based. For this purpose a press conference will be given every month in which a detailed analysis of the economic situation in general and especially the outlook for price developments will be presented. In addition the ECB publishes a monthly bulletin in every language of the Euro area and an annual report as well as more technical staff reports. In December 1999 the Governor of the ECB even announced to publish an inflation and growth forecast of the Bank in the near future. But, of course, transparency does not mean publishing the maximum amount of information available.15 As regards accountability, Jensen (1997) has shown that delegation improves suboptimal outcomes only to the extent that there are important "reappointment costs". These are the costs of changing the conditions under which monetary policy operates. As the EU Treaty can only be amended 15 In a recent paper Buiter (1999) offers a wide-ranging critique of the institutional arrangements and operating practices governing the activities of the Eurosystem. See also the reply in Issing (1999). Schmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 Overcoming the Inflationary Bias Through Institutional Changes 19 unanimously by all EU member states, the costs of reappointment seem likely to be higher for the ECB than for a typical national central bank before EMU. And weight conservatism might be especially important if fully state-contingent delegation is impossible which is especially true for the Eurosystem in the first years of its existence (Herrendorf/Lockwood, 1997). 8. Summary and conclusions Central banks of OECD countries and especially those of EU countries have undergone substantial changes in their institutional design. But the better the inflation track record the lesser these changes were. For example, the changes in the institutional framework of the Bundesbank were only minor. Regarding formal transparency, several central banks have also undergone significant changes while the Bundesbank has hardly changed in the past. Until the end of 1998 it could be characterised by a comparatively low degree of formal transparency about its actual decision making process and short-term monetary policy implementation strategies. This reflects the fact that the Bundesbank traditionally had a reputation of being a 'conservative central bank(er)' and that not much additional credibility could be 'gained' from revealing private information. It may also reflect a certain scepticism about the virtues of transparency as well as the view that more transparency about the decision-making process does not necessarily make the signal extraction problem of private agents easier (see also Issing, 1999). This sheds new light on the recent discussion about publishing the minutes of the meetings of the ECB council. To the extent that voting behaviour of the members of the central bank council of the ECB would depend on whether the minutes are published or not, efficacy of monetary policy would be reduced. As an alternative, the Bundesbank used its strategy of monetary targeting as a method of communicating monetary policy to the public. The objectives of monetary policy were always clearly stated by the Bundesbank, thereby enhancing transparency of monetary policy and accountability of the central bank. In this sense accountability of central banks is a necessary complement to granting central banks independence. The ECB clearly stated that the most important aspect of accountability is the actual inflation track record. To ensure successful policy, it is essential to convey to the public a sense of reasoning behind the decisions of the Governing Council and a coherent summary of the information upon which decisions are based. But this does not mean publishing every information. The changes which have taken place on the part of central banks and are reflected in the institutional design of the ECB clearly have an impact on the behaviour of the private and public sector. Especially, inflation expectaSchmollers Jahrbuch 120 (2000) 1 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/schm.120.1.1 | Generated on 2023-04-04 12:27:05 20 Sebastian Schich and Franz Seitz tions are influenced. In this sense all these changes may mark a structural break in the monetary policy transmission process. The monetary policy strategy chosen by the Eurosystem which may be interpreted as a combination of rules and discretion seems to be the right answer to this challenge. But only time will show whether the Eurosystem will be successful. References Alberola, E. /Marqués, J. M./Sanchís, A. 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