Why central banking is defined by discretion, not just rules
In short: For decades, economists believed the perfect central bank could operate like a machine, following strict rules to ensure stability. But as the 1970s instability and the 2008 financial crisis proved, the line between rule-based targets and human discretion is far more blurred than we once thought.
In the 1970s, the near loss of price stability forced a fundamental rethink of economic management. Policymakers realized they had to account for how households and firms change their behavior based on economic expectations. This led to the development of models favoring price stability through interest rate feedback rules. For a period known as the Long Expansion, this approach appeared successful, creating a consensus that monetary policy could be separated from other economic levers.
This 'separation principle' suggested that a central bank could focus solely on inflation targets through operational independence, while fiscal and financial policies were partitioned off. The goal was to create an alloy of targets and beliefs so strong that the public would act in ways that supported stability. If people expected stability after a shock, the central bank wouldn't need to resort to painful interest rate hikes or recessions to prove its commitment. In this ideal, the central bank functions as a rule-based machine.
However, the financial crisis challenged this separation. The link between financial and monetary stability proved to be inseparable. The failure to secure financial stability directly threatened price stability. As noted in the June 2010 Mansion House speech, the Bank of England's responsibilities began to recombine, integrating micro-prudential regulation and macro-prudential control. This shift suggests that monetary policy cannot be easily isolated from the broader constraints of fiscal policy, financial regulation, and even the actions of overseas policymakers.
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Sources
- Summary by Intellect · source: The Science of Monetary Policy - Professor Jagjit Chadha
- Also: The Science of Monetary Policy
- Also: niesr.ac.uk — Jagjit S Chadha - NIESR
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