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Monetary Policy In The UK  |  The Current Inflation Target  |  An Independant Bank of England

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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