Contents
Summary
I. Introduction
II. How Inflation Targeting Works
III. The Experience with Inflation Targeting
IV. VAR Analysis
V. Conclusions
Tables
1. Out-of-Sample Prediction Errors
Figures
1. Retail Price Inflation (RPIX)
2. International Comparisons of Inflation Performance
3. Market Indicators of Monetary Credibility
4. Monetary Policy and Growth
5. Prediction of Errors of VAR (United Kingdom)
6. Prediction of Errors of VAR (France)
7. Prediction of Errors of VAR (Italy)
Appendix I
Bibliography
Summary
The United Kingdom adopted an inflation target for monetary policy more than five years ago, in response to the failure of money supply targets and, subsequently of the exchange rate link to the ERM. The framework ushered in a period of moderate inflation—close to the 2½ percent target for most of the period. The incoming Labour government made important modifications in the framework, notably granting operational independence to the Bank of England.
This paper discusses the conduct of monetary policy with inflation targets and the implications of recent changes. The revised framework (in place since May 1997) preserves the transparency features of the U.K. approach to inflation targeting while insulating policy from short-term political considerations, and is thus likely to boost monetary policy credibility.
The favorable inflation performance must be viewed in the context of a trend toward lower inflation in other industrial countries—although the United Kingdom would not likely have shared in that trend had suitable monetary policies not been in place. Inflation targeting was not particularly well received in the markets: market indicators of expected inflation were slow to decline even after the decline in actual inflation became evident.
A vector autoregression (VAR) is used to examine whether the behavior of inflation and other key variables changed with the introduction of inflation targeting. Results indicate that inflation has been consistent with what would be predicted based on past relationships involving cyclical conditions, past inflation, interest rates and exchange rates, but both short-and long-term interest rates have been lower than predicted. This is consistent with the interpretation that credibility gains associated with inflation targeting permitted inflation to decline and long-term interest rates to be lower than predicted despite a significant monetary easing.