Inflation targeting: The UK experience

1. Inflation targeting: The UK experience Charlie Bean Executive Director and Chief Economist Bank of England Central Bank of Hungary, 19 January 2007

2. Outline • Framework • Process • Performance • Communication • Issues

3. How did UK get here? • Until 1972: Fixed but adjustable exchange rates; fiscal policy to manage demand • 1972-79: Active fiscal policy; inflation control through incomes policy • 1979-86: Monetary target (MTFS) • 1986-90: Shadowing the Deutsch Mark • 1990-92: Exchange Rate Mechanism • 1992-97: Inflation target; Chancellor sets rates • After 1997: Inflation target; MPC sets rates

4. Objective • Statutory objective (Bank of England Act 1998) • “To maintain price stability, and subject to that, to support the economic policy of HM Government, including its objectives for growth and employment” • Annual Remit from Chancellor • “Price stability” = 2% CPI inflation at all times • Recognizes can’t achieve 2% continuously; gives MPC “constrained discretion” • Open Letter if inflation falls outside 1%-3% range • Operational – not goal – independence

5. Composition of MPC • Five Bank and four external members • All bar two appointed by Chancellor • Technocratic rather than representative • Majority voting, not consensus-seeking • Non-voting Treasury representative

6. Monthly MPC round Continuous briefing notes & analysis Pre-MPC meeting - previous Friday MPC discussion - Wednesday MPC policy decision - Thursday Statement - Thursday 12 noon Minutes - within 2 weeks

7. Quarterly forecast round Benchmark forecast Key issues meetings 1,2 Draft forecast meetings 1,2 Policy decision Inflation Report

8. November GDP growth projection

9. November CPI inflation projection

10. Projections and policy • Decision focuses on medium-term prospect for inflation (≈ 2 years out)… • …but no mechanical link • Prospects for activity and inflation before and beyond two years matters • Nature of shocks matters • Balance of risks matters • Substantial re-evaluation of prospects more likely in Inflation Report months

11. Inflation Percentage change on year earlier 30 RPI Inflation Target Start of 25 targeting changes to 2% MPC introduced 20 CPI 15 10 CPI 5 0 1970 1975 1980 1985 1990 1995 2000 2005

12. GDP growth Percentage change on year earlier 12 10 Inflation targeting Start of Target 8 introduced MPC changes to 2% CPI 6 4 2 0 -2 -4 -6 1970 1975 1980 1985 1990 1995 2000 2005

13. Inflation expectations

14. MPC’s forecast record Mean Mean abs. Central Central error error 30% 50% RPIX inflation 1-year ahead (24) 0.0 0.3 46% 63% 2-years ahead (22) -0.3 0.4 36% 82% GDP growth 1-year ahead (25)0.5 0.8 32% 52% 2-years ahead (21)0.3 0.7 24% 71%

15. Performance • Inflation closer to target than could have been expected (no Open Letters…yet!) • GDP growth stable • Inflation expectations well-anchored • Still uncertainty over how much is down to: • Small/benign shocks • Structural changes • New monetary framework

16. Communications • Policy communications • Press statement • Minutes • Inflation Report • Open Letter • Speeches • Technical communications • Economic model book • Working papers • Quarterly Bulletin

17. Should CBs announce a rate path? • Some academics argue for this • Should help to anchor market expectations • RBNZ, Norges Bank & (soon) Riksbank do it • Against: • Mis-direction of policymakers’ effort • Public may take announced path as a promise • Choice really between explicit and implicit communication about rate prospects

18. August 05: market interest rates

19. Aug 05 CPI projection: market rates

20. Aug 05 CPI projection: constant rates

21. Issues • How have globalisation and inflation targeting affected pricing dynamics and policy multiplier? • How should inflation targets incorporate developments in asset prices? • [The relationship with fiscal policy]

22. Changes in pricing dynamics • Anchoring of inflation expectations and globalisation have: • Reduced response of inflation to demand shocks

23. UK Phillips Curve

24. Changes in pricing dynamics • Anchoring of inflation expectations and globalisation have: • Reduced response of inflation to demand shocks • Reduced inflation persistence; expectations do the work

25. Frequency of price changes

26. Changes in pricing dynamics • Anchoring of inflation expectations and globalisation have: • Reduced response of inflation to demand shocks • Reduced inflation persistence; expectations do the work • Pass-through of cost shocks also reduced

27. Response to lower profit margins

28. Energy and non-energy inflation

29. House price to earnings ratio

30. Asset prices and inflation targets • How should policy react to asset price booms? • Concern is financial instability, credit crunch that may accompany an asset price correction • Entirely consistent with inflation targeting, but need to look beyond the usual medium-term horizon • But practical difficulties in implementation • Need to identify cause of asset price boom • Transmission lags imply only narrow window for pre-emptive policy • Small rate increases unlikely to be effective, but large increases imply large short-term costs

31. Fiscal policy • Government has two fiscal rules • ‘Golden rule’: current budget balanced over cycle • ‘Sustainable investment rule’: net debt/GDP held at a sustainable and prudent level (40% of GDP) • Ensures fiscal policy sustainable, but allows automatic stabilisers to work • Fiscal policy has supported monetary policy • No co-ordination issue • Chancellor sets MPC’s objective • Knows our reaction function

32. Inflation targeting: The UK experience THE END www.bankofengland.co.uk