This Selected Issues paper examines the operational independence and the conduct of monetary policy in the United Kingdom. The paper describes the inflation targeting framework and the analytics of the decision-making process. It suggests that inflation targeting, although not entirely new in terms of the basic idea, is a rather significant step toward establishing a workable and well-defined framework for monetary policy. The paper also describes structure, mandate, and policy issues associated with the financial services authority.

Abstract

This Selected Issues paper examines the operational independence and the conduct of monetary policy in the United Kingdom. The paper describes the inflation targeting framework and the analytics of the decision-making process. It suggests that inflation targeting, although not entirely new in terms of the basic idea, is a rather significant step toward establishing a workable and well-defined framework for monetary policy. The paper also describes structure, mandate, and policy issues associated with the financial services authority.

III. United Kingdom Business Cycle and EMU Entry55

A. Introduction

104. The U.K. government has announced five economic tests that would need to be met before entry into EMU. These tests require sustainable convergence between the United Kingdom and the EMU countries so that a unified interest rate policy would make economic sense; sufficient flexibility in the United Kingdom to cope with economic change; and grounds to believe that EMU will have favorable effects on investment, the financial services industry, and employment.

105. Of these tests (criteria) the first has been accorded prominence by both the authorities and outside commentators: it appears to be less ambiguous than the rest and it is the only one that clearly depends on the relative cyclical position of the U.K. economy. The other tests, by contrast, are more structural in nature and unlikely to be influenced by policy in the short term. They also seem intrinsically vague, which would make it harder to decide if they are met.56 The significance of the convergence test is heightened by the contention that historically U.K. business cycles have been more volatile than, and not particularly synchronized with, those of the prospective EMU members (Figure 1).57 The implication is that cyclical convergence may not occur naturally by the time that the United Kingdom may seriously contemplate joining (2002 the earliest).

Figure 1.
Figure 1.

Selected countries: Real GDP

Citation: IMF Staff Country Reports 1999, 044; 10.5089/9781451814088.002.A003

106. This Chapter examines the empirical properties of the U.K. business cycle, its relationship with those in major economies of Europe and North America, and its principal determinants. The objective is to evaluate the relevance of the convergence criterion and identify the factors (in particular policy variables) that will influence the likelihood of convergence.

107. The issue of whether cyclical convergence is a sensible criterion is not discussed in the Chapter. While, from a currency union point of view, there could even be advantages in requiring the opposite—countries with different cyclical positions may benefit from the resulting counteracting influences—the case in favor of the criterion is clearly strong: cyclical convergence, in particular to the extent that it implies convergence in policies, would indicate suitability for currency unification; it would also help ensure a smooth transition by diminishing the likelihood of exchange rate misalignment caused by cyclical differences. There is also a definitional issue that the Chapter does not discuss. The convergence criterion, although more transparent than the other four, still leaves plenty of room for interpretation. For example, it is not entirely clear whether the criterion simply requires that at the time of entry the United Kingdom and the EMU countries be in a similar cyclical position, or whether it addresses the more structural of issue of whether the cycles should become fundamentally more synchronized, both in relation to length and amplitude. While the primary aim of this Chapter is to throw light on the latter aspects of the problem—on the assumption that the latter condition implies the former in the medium term—, clearly the short-term cyclical issue remains of immediate relevance to policy makers.

108. The Chapter first provides new evidence on the main features of the U.K. business cycle, in order to put the convergence criterion in the relevant context. The results show that the business cycle in the United Kingdom is more correlated with those in North America than in Europe. They also demonstrate that the U.K. business cycles have not only been out of line with those in major European countries, but they have also been, on average, deeper and more volatile than elsewhere.

109. The Chapter then attempts to identify factors that have contributed to cyclical fluctuations in the United Kingdom in order to assess the areas where policy actions may be required to enhance the likelihood of convergence. Cycles in the U.K. may differ from those on the continent for principally three reasons: different policies or exogenous variables, different transmission mechanisms, and different idiosyncratic shocks. In algebraic terms suppose that output reacts to policy (and exogenous) variables in the following fashion: yi, t = AiZi, t + ηi, t + et where the subscript I refers to country, Zt is a vector of the explanatory variables, ηi, t an idiosyncratic or country specific shock, and et is a common shock. In this framework differences in policies, in transmission mechanisms, and in country-specific shocks are, respectively, reflected in differences in Zt, Ai, and ηi, t. This Chapter examines only the role of policy and exogenous variables in this regard. Clearly, different transmission mechanisms and/or idiosyncratic shocks could also play important roles.58

110. A cointegrating VAR model of the U.K. economy is estimated in order to examine the role of policies and the exchange rate in the U.K. business cycle. The estimation results provide evidence that monetary variables and the exchange rate have significantly contributed to GDP fluctuations. For example, the downturn during 1990-92 is largely explained by the interest rate and the exchange rate. These results emphasize the need, recognized by the authorities, for actively pursuing policies that will bring the U.K. economy closer to those on the continent and to contain fluctuations in the exchange rate. To this end, the government’s efforts to strengthen the medium-term focus of monetary and fiscal policies seem appropriate.59 The European Commission’s recent assessment of the U.K. economic policies also argues that these are fully consistent with prospective membership of the euro single currency.

111. The role of the exchange rate is clearly crucial: its volatility has been significant in causing growth fluctuations, implying that convergence is unlikely if circumstances that allow the exchange rate to have large swings continue; and the U.K.’s brief experience with the ERM illustrates the harmful effects of entering a single currency at a wrong rate. There is, therefore, the issue of how to reduce volatility in the exchange rate and how to ensure that an appropriate exchange rate is achieved prior to EMU entry. The option of joining an exchange rate mechanism as a preliminary step to joining EMU is not considered viable by the U.K. authorities. While the medium-term orientation of fiscal and monetary policies may help stabilize the exchange rate, specific actions close to the time of entry may also be required to influence the entry rate. The dilemma facing the policy makers is that such action, in particular if it implies procyclical monetary policy, could exacerbate cyclical differences with Europe and jeopardize the medium-term objectives of policies.

112. Notwithstanding the case for policies that enhance the likelihood of convergence, the estimation results may also be looked at from the opposite angle. One could argue that, given the historical divergence between cycles in the United Kingdom and those on the continent and given the drawbacks of delaying the entry significantly, applying a reasonable degree of pragmatism in evaluating the cyclical convergence criterion may be warranted. Moreover, stability-oriented policies are only likely to lower cyclical fluctuations over the medium term and may not necessarily weaken the impact of idiosyncratic shocks.

B. Properties of the U.K. Business Cycle

113. Decomposing GDP into cycles and other components is inevitably hampered by definitional uncertainties. In general terms a time series may comprise of three types of components: trends, cycles—both of which may include stochastic terms—, and shocks. The problem is that there are no generally acceptable methods to separate these. Moreover, different methods often yield apparently different results. While one may set criteria that help in choosing from among the various methods, depending on the particular features of the cycle that one is interested in, there is clearly a great degree of arbitrariness.60

114. This section examines the U.K. business cycle and its relation to those in other major countries, using two distinct approaches. The first approach uses the Hodrick-Prescott (HP) filter to define “growth cycles” as deviations from the trend. This concept of the cycle is closely related to the output gap. An HP filter (with a parameter of 1600) is applied to quarterly GDP data for the United Kingdom, United States, Canada, Germany, France, and Italy.61

115. The second method identifies and compares business cycle turning points using a simple 2-consecutive change rule (see below). The method allows a separate examination of the characteristics of expansions and contractions while avoiding the de-trending component of methods such as the HP filter, which may, under certain conditions, induce spurious cycles (see King and Rebello, 1993, and Osborn, 1995, for example).

Synchronization between cycles

116. Table 1 reports coefficients of correlation between growth cycles in different countries, based on the HP filter. It demonstrates that the cycle in the United Kingdom is more correlated with those in the United States and Canada than in Germany, France or Italy.62 The table also shows that correlation between the United States and Canada, on the one hand, and between France, Germany and Italy, on the other hand, are strong.63

Table 1:

GDP Correlation Coefficients for Growth Cycles (HP Filter)

article image

117. Table 2 reports results using business cycle turning points. A binary time series variable is defined for each country, denoting periods of expansion with ones and contraction with zeros. Turning points are obtained if any two or more consecutive observations are above the mean growth (upswing) or below the mean (downswings). The classification into binary zero-one variables makes similarities and differences appear more pronounced. These binary variables may be used to construct conventional contingency tables and Pearson’s contingency coefficients.64 The results reported in Table 2 are in line with those obtained using the HP filter: the U.K. business cycle is relatively more correlated with those in North America than in Europe; that there is considerably more correlation within Europe than between the United Kingdom and Europe; and finally that there is very little correlation between the European countries’ business cycles and those in either the United States or Canada.

Table 2:

Counts and Correlation of Business Cycles Regimes (relative to Mean) for the United Kingdom and Germany 1/

article image

A downturn (upturn) regime is denoted by 0 (or 1) and is defined as two consecutive declines (increases) below (above) the mean. Nij, i, j=0, 1 denotes the number of occurances (quarters) of regime i in UK (or Germany in the middle panel) and regime in the other countries.

Volatility of cycles

118. The U.K. business cycles have not only been out of line with those in major European countries, they have also been, on average, deeper and more volatile than elsewhere. The variance of U.K.’s GDP growth (over the period 1960-97) is significantly higher than those in France, Germany, and Italy. For example, it is twice as high as that in France (Table 3). In addition, as a result of the higher frequency and severity of recessions, the cumulative decline during all downturns (defined as two consecutive absolute declines) has also been higher in the United Kingdom (Table 4); and GDP in the United Kingdom has increased by a smaller degree over the period (83 percent, compared with 115 per cent in the United States, 130 percent in Canada, and 115 per cent in France.)65

Table 3:

GDP Growth—Descriptive Statistics (1960:1-1997:4) 1/

article image

** denote significance at 5 percent level

Table 4:

Cumulative Change in GDP

(In percent) 1/

article image

Based on 2-consecutive change rule (below/above zero)

119. It is also interesting to compare the three “common” cycles for the major industrial countries over this period, with downturns during 1973-75, 1980-82, 1990-93. Table 5 compares the duration of the downturns and the decline in GDP for each recession.66 This information reveals the longer duration of the downturns in the United Kingdom, in comparison with the other countries. For example the last recession in the beginning of the 1990s lasted 8 quarters in the United Kingdom compared with 3 in the United States, 4 in Germany, and 5 in Italy.

Table 5:

Duration and Depth of Major Recessions - GDP 1/

article image

Cycles defined with 2-consecutive change rule (below/above zero)

C. Policy Variables and the Cycle: A Structural VAR Analysis

120. This section estimates a system of co-integrating structural VAR in order to assess the contributions of policies and the exchange rate to business cycles in the United Kingdom.67 Any such exercise by nature is tentative because of the large degree of arbitrariness that exists in choosing from among competing VAR specifications. The principal source of arbitrariness is the fact that restrictions need to be imposed to identify the system, thus inhibiting thorough cross comparison of alternative VARs.

121. We use the Mundell-Flemming model to provide a broad framework for analysis: in the goods market output (y) is determined by the real interest rate (I-π), the real effective exchange rate, defined as the price of domestic currency times relative prices (e), real money balances (m-p), and real government expenditure (g); in the money market supply of money is set equal to demand for money, expressed as a function of income and the interest rate; and in the capital market, the interest rate parity condition, for given exchange rate expectations and relative prices, implies a relationship between the exchange rate and domestic and foreign interest rates (all variables are in logarithms, except for the interest rate):68

y=Φ(iπ,e,mp,g)mp=f(y,i)e=h(i,i*)

122. The econometric methodology followed here has been reviewed extensively in the academic literature—see for example Johansen (1988a, b and 1995), Hendry (1995), Doornik and Hendry (1997) and references therein. Denoting by zt the vector which includes all the variables of interest, the VAR system takes the form:

zt=Σi=1mπizti+vt(1)

This can be written in the error correction form as:

Δzt=Σi=1m1δiΔzti+α(βzt1+γqt)+vt(2)

if αβ′zt-1 is I(0), that is if there exists at least one co-integrating vector between the variables in zt. The term in parentheses represents the error correction mechanism, with β the cointegrating vector and α measuring responsiveness to error correction (or to the extent of long-term disequilibrium in the system). Deterministic effects are included in γ′qt. Once the model is estimated and the number of co-integrating relationships established, the task is to identify unique co-integrating relationships that are consistent with economic theory.

123. The model includes real money, real GDP, the nominal short-term interest rate, the real effective exchange rate, and real government expenditure.69 All variables are difference stationary. Thus, a VAR in levels—with 5 lags and a constant term—is estimated. This is referred to below as the I(1) system. The sample period is 1963Q1-97Q4. F tests confirm that all five lags are significant for the system as a whole and therefore retained in the second step which begins by testing for co-integration. The supporting diagnostics (not reported here) show no evidence of autocorrelation or heteroskedasticity, but reveal the absence of error normality. The latter problem largely—but not totally—disappears by adding dummies to account for sterling’s sharp fall in 1992Q4.

124. Testing for co-integration is carried out using the Johansen procedure (see Johansen, 1988a,b). Both the maximum eigenvalue (max) and trace statistics (tr) without and with an adjustment for degrees of freedom - dof -- as suggested by Reimers (1992), are tabulated in the Table 6. The tests reveal three, possibly four, long-run relationships. Visual inspection suggests that only the first three are stationary and consequently we proceed with the hypothesis that the rank of the II matrix is three. The system is re-estimated with the rank restriction imposed.70

Table 6.

Tests for Co-integration 1/

article image

Restricted intercept, no trend

125. The standardized co-integrating vectors obtained are just one representation of the co-integrating space and any linear combination is also admissible. In other words, the long-run relationships are not uniquely identified. Consequently, economic theory should guide us in deciding on a suitable representation that uniquely identifies the system.

126. To identify the long-run relationships we need at least nine restrictions on the parameters.71 The theoretical model imposes five restrictions on the β matrix, and normalization imposes another three. The remaining one restriction is imposed on α. These restrictions together allow the identification of the system. Additionally, seven over identifying restrictions are imposed on the elements of a as implied by the statistical significance of the entries of this matrix (see Table 7). These are tested jointly and not rejected (LR-test χ2(7) = 10.56 [0.1590]—see Hendry and Doornik, 1997, for details of the test.)

Table 7.

Dynamic Equations with Error Correction Terms—Estimated by FIML 1/

article image

Indicates that the variable is significant at the 10 per cent level.

127. The estimation yields the following set of co-integrating relationships (corresponding to β′zt relationships described above):

C1=y0.26m+0.17i+0.22e0.34g4.4C2=m1.8y+6.2i+3.0C3=i+0.6e2.9

The long-run coefficients implied by the cointegrating equations have signs that are consistent with the framework described above. Goods market equilibrium, equation C1 suggests that output is positively related to money and government expenditure, and negatively to the interest rate and the exchange rate. Money market equilibrium, C2 implies that demand for money is negatively to the interest rate and positively to income. Finally, equation C3 could loosely be interpreted as an interest rate parity condition, such that the interest rate adjusts in the opposite direction to the exchange rate.

128. Given that three co-integrating relationships exist, the system can be re-written in first differences, as in equation (1), with co-integrating vectors C1 C2, and C3 as error-correction terms. The estimation results for this equation, using full-information-maximum likelihood, are reported in Table 7.72

The estimated equation for the growth of GDP, as reported in Table 7, is:

Δy = -0.126 C1,t-1 -0.016 C2,t-1 + Other terms

129. This equation tracks adequately the business cycle fluctuations in GDP (Figure 2, top panel). The correlations of the actual and fitted values for this equation is 0.58, compared with 0.21 obtained by a simple AR(4) process.

Figure 2.
Figure 2.

United Kingdom: Actual and predicted GDP growth

Citation: IMF Staff Country Reports 1999, 044; 10.5089/9781451814088.002.A003

130. The results suggest an important role for monetary conditions in explaining fluctuations in economic growth. This is illustrated, for example, by the strong feedback to disequilibrium in the goods market, as shown by C1 which mainly reflects changes in monetary conditions (movements in the interest rate and the exchange rate). It is, perhaps more clearly, also illustrated in Figure 2, bottom panel, which plots actual and predicted GDP growth in a model which removes the interest rate and the exchange rate. In this case, the correlation between the actual and fitted values falls to 0.39. It is obvious, for example, that the downturn during 1990-92 is completely missed by this model.

D. Conclusions

131. This Chapter provides evidence in support of the view that output fluctuations in the United Kingdom have been larger than in other major industrial countries, and relatively more in line with those in North America than those in major European countries. In addition, estimation results from a cointegrating VAR system identify important roles for the interest rate and the exchange rate in generating output fluctuations in the United Kingdom. This is particularly the case during the downturn of the early 1990s and the upswing that followed it.

132. The implication is that to moderate output fluctuations and increase the likelihood of cyclical convergence there is a need to pursue more stable policies, and to contain fluctuations in the exchange rate. To this end, the government’s efforts to strengthen the medium-term focus of monetary and fiscal policies seem appropriate. At the same time policy makers face a dilemma in that while more stable policies may in the long term help stabilize the exchange rate, this may not necessarily be the case in the short-term. For example, reducing exchange rate misalignment in the short-term may imply procyclical monetary policy, which could exacerbate cyclical divergence and jeopardize the medium-term objectives of policies.

133. While the analysis clearly illustrates the cost (in terms of lower likelihood of convergence) of policies that destabilize output, one may also argue that given the historical properties of the U.K. cycle and given the drawbacks of delaying the entry significantly, it may be necessary to apply a reasonable degree of pragmatism in evaluating the cyclical convergence criterion, in particular if countries such as Ireland, Spain, and Portugal, despite their cyclical positions, successfully take part in EMU. Clearly, however, this should not be at the expense of attempts to strengthen the likelihood of convergence, which would indicate suitability for currency unification and would help ensure a smooth transition.

References

  • Artis, M.J., Kontolemis, Z.G., and Osborn, D.R., 1997, “Business Cycles for the G7 and European Countries”, The Journal of Business, vol 70, no.2, 249-279.

    • Search Google Scholar
    • Export Citation
  • Artis, M.J. and Zhang, W., 1995, “International Business Cycles and the ERM: Is there a European Business Cycle?”, International Journal of Finance and Economics, 2:1-16.

    • Search Google Scholar
    • Export Citation
  • Britton, E. and Whitley, J., 1997, “Comparing the monetary transmission mechanism in France, Germany, and the United Kingdom: Some issues and results”, Bank of England Quarterly Bulletin, (May), Vol. 37, No. 2.

    • Search Google Scholar
    • Export Citation
  • Buiter, W.B., 1999, “Britain and EMU”, Bank of England mimeo., February.

  • Burnside, C., 1998, “Detrending and Business Cycle facts: A comment”, Journal of Monetary Economics, 41:513-532.

  • Canova, F., 1998, “Detrending and Business Cycle facts”, Journal of Monetary Economics, 41:475-512.

  • Christodoulakis, N., Dimelis, S. and Kollintzas, T., 1995, “Comparisons of Business Cycles in the EC: Idiosyncrasies and Regularities”, Economica, 62, 1-27.

    • Search Google Scholar
    • Export Citation
  • Doornik, J.A. and Hendry, D.F., 1997, Modelling Dynamic Systems using PC Fiml 9.0 for Windows, International Thompson Publishers.

  • Engle, R.F. and Kozicki, S., 1993, “Testing for Common Features”, Journal of Business and Economic Statistics, vol.11, no.4, 369-395 (with discussion).

    • Search Google Scholar
    • Export Citation
  • Fetherston, M., 1998, “Ireland and the United Kingdom: Diverging Approaches to EMU”, mimeo., European Department, IMF.

  • Garratt, A. Lee, K., Pesaran, M.H. and Shin, Y., 1997, “A Long Run Structural VAR Model of the UK Economy”, mimeo, University of Cambridge.

    • Search Google Scholar
    • Export Citation
  • Hendry, D.F., 1995, Dynamic Econometrics, Oxford:Oxford University Press.

  • H.M. Treasury, 1998, “Delivering Economic Stability: Lessons from Macroeconomic Policy Mix”, The Pre-Budget Report, November.

  • Johansen, S., 1988a, “Statistical Analysis of Cointegrating Vectors”, Journal of Economic Dynamics and Control 12:231-54.

  • Johansen, S., 1988b, “Maximum Likelihood Estimation and Inference on Cointegration—with Applications to the Demand for Money”, Oxford Bulletin of Economics and Statistics 52:169-210.

    • Search Google Scholar
    • Export Citation
  • Johansen, S., 1992, “Testing Weak Exogeneity and the Order of Cointegration in U.K. Money Demand”, Journal of Policy Modelling 14:313-34.

    • Search Google Scholar
    • Export Citation
  • Johansen, S., 1995, Likelihood-Based Inference in Cointegrated Vector Autoregressive Models, Oxford:Oxford University Press.

  • King, R.G. and Rebello, S.T., 1993, “Low frequency filtering and real business cycles”, Journal of Economic Dynamics and Control, 17:207-31.

    • Search Google Scholar
    • Export Citation
  • Obstfeld, M. And Peri, G., 1998, “Regional non-adjustment and fiscal policy”, Economic Policy, April:207-259, with discussion.

  • Osborn, D.R., 1995, “Moving Average de-trending and the analysis of business cycles”, Oxford Bulletin of Economics and Statistics, 57:547-58.

    • Search Google Scholar
    • Export Citation
  • Ramaswamy, R. And T. Sloek, 1997, “The real effects of monetary policy in the European Union: What are the differences?” IMF Working Paper 97/160 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Sachs, L., 1985, Applied Statistics, Springer-Verlag.

  • Siegel, S. And Castellan, N.J., 1988, Nonparametric Statistics, McGraw-Hill.

STATISTICAL APPENDIX

Table A1.

United Kingdom: Real Output and Its Major Components at Constant Factor Cost

(Percentage change over preceding year)

article image
Source: Office for National Statistics, Economic Trends.

Includes oil and gas extraction.

Based on output data.

Table A2.

United Kingdom: Labor Market Indicators

(In thousands)

article image
Source: Department of Employment, Employment Gazette.

Not adjusted for seasonal variation.

Estimates of the self-employed, with or without employees, are based on labor force surveys for data through 1990, and on Department of Employment estimates thereafter.

Great Britain, percent of total.

Table A3.

United Kingdom: Selected National Accounts Aggregates at 1990 Market Prices

article image
Sources: Office for National Statistics, Economic Trends.

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.

An unweighted average of expenditure, income, and output estimates.

Contribution to growth of GDP (average estimate).

Average measure in billions of pounds.

Table A4.

United Kingdom: Selected Personal Sector Data

(In percent of GDP)

article image
Sources: Office for National Statistics, Financial Statistics, Economic Trends; and staff estimates.

No longer calculated by Central Statistics Office.

Table A5.

United Kingdom: Components of Personal Income

article image
Source: Office for National Statistics, United Kingdom National Accounts.

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.

In 1990 prices, deflated by the implied deflator for consumers’ expenditure.

Relative to personal disposable income.

Contribution to growth in disposable income.

Table A6.

United Kingdom: Selected Financial Statistics - Industrial and Commercial Companies

(In percent of GDP)

article image
Source: CSO, Financial Statistics.

Net of stock appreciation.

Bank borrowing and other loans less bank deposits.

Large companies.

Ratio of interest payments to post-tax income.

Table A7.

United Kingdom: Selected Indicators of Investment Activity

article image
Source: Office for National Statistics, United Kingdom National Accounts.

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.