Has more Independence Affected Bank of England's Reaction Function under Inflation Targeting? Lessons from Taylor Rule Empirics

This paper is an empirical investigation into the question of whether increased independence affects central bank behavior, in particular when monetary policy is already in an inflation targeting regime. We take advantage of the unique experience in that sense of the United Kingdom, where the Bank of England was granted operational independence from Her Majesty’s Treasury only in May 1997, while inflation targeting had been implemented since October 1992. Our strategy is to estimate Taylor rules employing alternative specifications, econometric methods and variable proxies in search for robust results that survive most of those modifications. The key lesson we extract from UK quarterly data is that the Bank of England has responded to the output gap, and not at all to output growth, the more so after receiving operational independence, when the gap has been positive or close to zero and inflation credibly stabilized at target. We find no unambiguous evidence for any definite change in the Bank’s reaction to inflation or in the degree of its interest rate smoothing. Our main import is to argue that both the asymmetry of the monetary policy reaction function across the cycle and the response to the output gap, not growth, are fully consistent with New Keynesian theory, especially under inflation targeting. Anchored inflation and economic expansion during the post-independence period thus complement greater autonomy in influencing the behavior of the Bank of England, yet clear separation of the individual contribution of each of these effects appears challenging given our short sample.