The Bank of England's increased influence on monetary policy has so far proved to be beneficial, says David Smith, but many fear that, come a general election, its inflation concerns would be swept aside.
It is now two-and-a-half years since the Bank of England began its phoenix-like rise from the ashes of Britain's ERM disaster. Most would agree, I think, that a little bit of independence has done the Bank, and the economic policy process, a lot of good.
The Bank's gradual move towards greater independence - just to recap - has occurred in several stages. The initial move came in the wake of Black Wednesday (16 September 1992) when the Government was searching desperately for something - anything - that would re-establish some credibility in policy, at a time when the centrepiece of its economic strategy (membership of the ERM) had been blown away.
And so the then chancellor, Norman Lamont, announced that the Government would henceforth operate within a defined target range for inflation (of 1% to 4% for underlying inflation excluding mortgage interest payments). Moreover, it would be the Bank's job to report each quarter on whether the Government was on course to achieve its target.
This was a significant change. In the past, Bank-watchers had needed to read between the lines of its quarterly bulletin to judge whether or not Threadneedle Street agreed with the Treasury's policy stance. With the new inflation report, it would be in black and white. A Bank forecast of above-target inflation would be an upfront statement of disapproval and, by implication, a requirement that policy (for this, read interest rates) needed to be changed.
The other change at this time was the establishment of regular monthly meetings between the chancellor and the Bank governor, together with attendant officials, to determine on the basis of the latest evidence and the inflation outlook, whether interest rates needed to be changed. The increase in the Bank's policy input from the days of Nigel Lawson's chancellorship in the late 1980s ('We take the decisions, they do the work') was considerable.
The original Lamont framework has been built upon. Kenneth Clarke decided that the minutes of these meetings should be published (mainly to protect himself from the charge that interest rate decisions were politically determined). Not only that, but when a decision to change interest rates was taken at one of these meetings, the precise timing was left to the Bank's discretion.
Another smaller change has been to give the Bank operational control over the management of government debt (when to issue gilts, and of what maturity). The Bank had also seized on what may have started as a throw-away comment by Lamont to the effect that the Government should aim for the lower half of its inflation target range by the end of the Parliament. Shortly after joining the Bank as deputy governor, Rupert Pennant-Rea hardened this by saying that the effective target inflation range, given that policy had to look a couple of years ahead, was a very tight 1% to 2.5%.
There has also been a subtle change in the presentation of interest rate changes. Since base rates began to rise in September 1994, headlines have tended to attribute upward moves in rates to the governor, Eddie George. Like the people in British Gas advertisements, who flick their fingers and get an instant flame, he is 'in control'. (Reductions in interest rates are still attributed to the chancellor on the grounds that no governor is likely to press for lower base rates).
The proof of the pudding in the new policy arrangements is in the record. So far, it has been a success. The aim, of raising interest rates as a 'stitch-in-time' action - before inflation has taken hold - is intended to limit the amount that rates will need to be raised in total to keep inflation under control. If this succeeds, and Britain avoids the wild swings in rates seen in the past, it will be a notable achievement.
The Bank's enhanced and very public input into monetary policy-making has brought with it greater freedom to speak out on other matters. The governor felt able to declare his position on European monetary union and a single currency recently, arguing that the dangers of economic stagnation, high unemployment and massive fiscal transfers had been understated in the debate.
Most observers, as I say, would accept that the new arrangements have worked well. Britain would find it hard to adjust easily to full central bank independence but quasi-independence is a good old-fashioned British compromise. Cautious central bankers act as a check on potentially irresponsible politicians. But they do not have full freedom to inflict over-restrictive policies on the economy.
The test of the new arrangements, however, is yet to come. We have already had a flavour of this when the governor, asked by the House of Commons Treasury and Civil Service Committee, how he would respond to large pre-election tax cuts, replied that he would not respond very favourably at all. But if the Government sees such tax cuts as its only route to electoral salvation, would the Bank be able to prevent them?
After all, even fully independent central banks, such as the German Bundesbank and the US Federal Reserve Board, recognise that they have to operate within a political environment. At the very least, this can mean postponing rate rises during politically sensitive periods. This is why, notwithstanding the success so far of greater independence for the Bank, the financial markets are not prepared to give the new arrangements the benefit of the doubt. There is still a fear that, come the run-up to a general election, the Bank's inflation concerns will be swept aside.
It may be that such fears underestimate the Bank's new influence, and that all concerned have too much to lose from the adoption of irresponsible policies. We shall see. For the Bank, the test is yet to come.
David Smith is economics editor of the Sunday Times.