Monetary Policy in the UK
money targets
exchange rate targets
inflation targets
a symmetrical inflation target
from RPIX inflation.
.to CPI inflation
The UK's current monetary policy framework has evolved from
past experiences and circumstances. Although the aim of policy
- price stability - and the instrument - the official Bank Rate - have remained virtually unaltered, the framework in
which monetary policy is conducted has undergone several changes,
most recently in December 2003.
money targets
Up until the 1970s, monetary policy included direct controls
on the amount of lending that banks were allowed to undertake.
This restricted the amounts people could borrow. These controls
had been abolished by 1980. In the 1980s, monetary policy was
conducted by trying to control the overall amount of money in
the economy. Targets were set for the growth of money (notes,
coins, bank deposits) and interest rates were varied accordingly.
However, measures of the amount of money in the economy were
not always a good guide to demand and inflation.
measures of the amount in the economy were not always a good
guide to demand and inflation
So by the mid-1980s, monetary policy was based on an assessment
of a broader range of economic indicators rather than a single
measure of money supply growth.
exchange rate targets
The purpose of an exchange rate target is to link monetary
policy and inflation in one country with that of another or
others. In the late 1980s, monetary policy was being constrained
by the objective of holding the exchange rate at a certain level.
For a period, this was around three Deutsche Marks to the pound
(DM3 = £1).
In 1990, the UK entered the European Exchange Rate Mechanism
(ERM). Monetary policy had to be set to ensure that the pound
did not strengthen or weaken by more than a certain amount against
other currencies in the system.
differences in economic conditions across Europe created tensions
between setting the interest rate to maintain the exchange rate
and that required for domestic economy
But, in 1992, differences in economic conditions across Europe
created tensions between setting the interest rate to maintain
the exchange rate and that required for the domestic economy.
In particular, the reunification of West and East Germany led
to strong growth and inflationary pressures there. Consequently,
German interest rates were high. The UK, on the other hand,
was emerging from recession, with slow growth and falling inflation.
Maintaining sterling's position in the ERM limited the scope
for reducing interest rates below those in Germany to a level
that would have been better for the UK economy. Investors had
little confidence in UK policy and did not want to hold sterling.
The resulting downward pressure on sterling's exchange rate
culminated in a suspension of ERM membership on 16 September
1992 and a sharp depreciation of the exchange rate.
inflation targets
After sterling's exit from the ERM, the Government decided
to adopt for the first time an explicit target for inflation.
Instead of targeting something like the exchange rate as a means
of controlling inflation, a rate for inflation itself was targeted.
Interest rates were set to ensure demand in the economy was
kept at a level consistent with a certain level of inflation
over time. Similar policies were already operating in New Zealand
and Canada, and have subsequently been adopted by other countries.
The first inflation target was set by the Chancellor of the
Exchequer to be an annual inflation rate of 1%-4%, with an objective
to be in the lower half of that range by the end of the 1992-97
parliament. The inflation target was subsequently revised to
be 2.5% or less.
interest rates are set to ensure demand in the economy is
kept at a level consistent with a certain level of inflation
During this time, interest rate decisions were taken by the
Chancellor of the Exchequer. However, the Bank of England was
asked to publish its own economic appraisals in a quarterly
Inflation
Report and was given the task of deciding the timing
of interest rate changes. Each month the then Chancellor - Kenneth
Clarke - met the then Governor of the Bank of England - Eddie
George - to discuss the level of interest rates. Although the
Governor could offer the Bank's advice about the level of interest
rates necessary to meet the Government's inflation target, the
decision remained the Chancellor's. These arrangements continued
until May 1997 when the new Chancellor - Gordon Brown - announced
a new policy framework.
a symmetrical inflation target
The Chancellor announced on 12 June 1997 that he was setting
an inflation target of 2.5%. The new target of 2.5% was quite
a significant change from the previous target of 2.5% or less.
The Treasury felt there were uncertainties about the old target
- was it 2.5% or less than 2.5%, and if so how much less? So
the new target was symmetrical. It was designed to give equal
weight to circumstances in which inflation is higher or lower
than the target rate. Inflation below the target was to be judged
as being just as bad as inflation above the target.
The target was symmetrical - inflation below the target was
to be viewed in the same way as inflation above it
So the remit was not to achieve the lowest possible inflation
rate - policy should not aim for an inflation rate below the
target. Interest rates should be set to ensure the level of
demand in the economy was consistent with meeting the inflation
target.
from RPIX inflation.
Between 1992 and 2003, the inflation target was expressed in
terms of an annual rate for a measure of retail price inflation
that excludes mortgage interest payments. This is known as RPIX
inflation - it is the annual change in the Retail Prices Index
(RPI) but does not include one of the RPI's components - the
interest paid on mortgages. Mortgage interest payments are an
important part of household expenditure and so they are included
in the RPI. But they will tend to rise if interest rates go
up. So an increase in interest rates designed to reduce inflation
would have the perverse effect of initially resulting in a rise
in inflation.
Between 1992 and 2003, the inflation target was expressed
in terms of RPIX - retail price inflation excluding mortgage
interest payments
.to CPI inflation
On 9 June 2003, the Chancellor announced that he planned to
change the inflation target to one based on the Harmonised Index
of Consumer Prices - the HICP - instead of RPIX. This would
be the first major change to the monetary framework introduced
since 1997.
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