Monetary policy in the United Kingdom has been conducted within a framework of inflation targeting combined, since May 1997, with operational independence of the central bank (see IMF Survey, March 9, 1998, page 78). An IMF staff study, “Operational Independence and the Conduct of Monetary Policy in the United Kingdom,” by Jan Kees Martijn and Hossein Samiei (to be included in a forthcoming IMF Staff Country Report on the United Kingdom) evaluates the experience thus far with this arrangement. While there are some potential weaknesses, the study concludes that the new monetary framework is appropriate for conducting a credible monetary policy.

Background

The decision in October 1992 to adopt inflation targeting was prompted by unsatisfactory experiences with monetary targeting in the 1980s and exchange rate targeting during the early 1990s. Inflation targeting, according to the IMF staffstudy, aims to be transparent in both the process and the result achieved by setting measurable objectives, being explicit about the processes that link instruments with targets, and specifying procedures for accountability. By following an explicit rule, inflation targeting helps enhance credibility, strengthening the medium-term focus of monetary policy. It also goes some way toward lowering the politically motivated inflationary bias in economic policy.

Under the inflation-targeting system adopted in 1992, the chancellor of the exchequer made interest rate decisions, taking into account the views of the central bank governor that were discussed in monthly meetings on monetary policy. An important feature of the new framework, which has increased transparency and accountability, was the publication of the Quarterly Inflation Report, containing the Bank of England’s inflation forecasts, and (starting in April 1994) the minutes of the monthly policy meetings between the chancellor and the governor.

Central bank independence

Under the new framework, the operation of monetary policy improved, and inflation appeared to be under control. However, some observers suggested that the new regime did not include sufficient protection against the inflationary bias: the government remained in control of the policy process, and no institutional safeguards existed against the use of unsustainable, politically motivated policy decisions.

In May 1997, the U.K. government took a crucial step to remedy this deficiency by giving operational independence to the Bank of England. At the same time, it adopted an explicit and symmetric point inflation target of 2½ percent and established the Monetary Policy Committee, consisting of Bank of England staff members and outsiders from the private sector and academia.

Under the new arrangement, the chancellor of the exchequer sets the inflation target in the annual budget, and the Monetary Policy Committee sets interest rates to achieve the target. In an effort to increase accountability, the Quarterly Inflation Report presents the views of Monetary Policy Committee members and the rationale for monetary policy decisions, as well as an assessment of developments and prospects. The report also presents projections for inflation and GDP over a two-year horizon. The minutes of the meetings, including the members’ votes, are published two weeks after the meetings take place. Moreover, if inflation deviates by more than 1 percentage point in either direction from the target, the governor is required to explain the reasons in an open letter to the chancellor.

The new framework implicitly recognizes that adopting a pure inflation target may limit the scope for macroeconomic stabilization and that the goal of stabilizing prices should not be at the expense of excessive fluctuations in output. The U.K. system attempts to deal with this problem. First, the focus on expected, rather than actual, inflation requires that the policy authority incorporate the behavior of other variables, including output, in its decisions, which helps in stabilizing demand shocks. Second, the new Bank of England remit stipulates that, without prejudice to the inflation target, the Monetary Policy Committee is expected to set interest rates so as to “support the general policies of the government, including its objectives for growth and employment.” This allows for stabilization of output as a secondary objective.

Transparency in the new framework

An important feature of the new monetary policy framework is increased transparency, in particular through the Quarterly Inflation Report and the minutes of the Monetary Policy Committee meetings. However, while transparency has been strengthened in many respects, the IMF study suggests that the credibility of inflation forecasting may have been weakened as a result of the transfer of decision making to the central bank. During 1992—97, before it was granted operational independence, the central bank, in effect, acted as an advisor to the government on monetary policy decisions and drew up independent forecasts. Since the Monetary Policy Committee took over the job of monetary policy decision making, the analysis and the inflation forecasts in the Quarterly Inflation Report no longer represent an independent assessment of monetary policy decisions. As a result, a situation in which the forecasts suggest that the two-year-ahead inflation target would be missed seems highly unlikely, because then the report would be questioning the committee’s own policy decisions. The problem is compounded, the staff study notes, by the Bank of England’s decision not to present an assessment of the likely future path of the interest rate. Instead, its primary inflation forecasts are made under the explicit assumption of unchanged interest rates, although, as the study notes, there is no reason to suppose that a policy that holds interest rates unchanged and delivers a two-year-ahead inflation of 2.5 percent is necessarily superior to other policies.

One way to strengthen the framework would be for the Bank of England to replace the assumption of unchanged interest rates in the inflation report with a more realistic and explicit discussion of the likely future path of the interest rate—a practice followed by the New Zealand Reserve Bank. Obviously, the bank would have to make it clear that it was not committing itself to a particular path, so that it could revise its projection at a later date without loss of credibility as new information became available.

Optimal policy mix

A fundamental implication of central bank independence is the separation of responsibility for monetary and fiscal policies. Most analyses of central bank independence, the staff study notes, do not take due account of the possibility that policy coordination may weaken, thus potentially off setting the benefits of the lower inflation bias. At the same time, the study acknowledges, when independence accompanies a general move toward more stable policies, the impact on macroeconomic stabilization is likely to be positive. The issue has gained increased significance in recent years, since the United Kingdom has not only adopted a more stability-oriented monetary policy but has also moved toward a more rules-based fiscal policy. Although both objectives may be worthwhile in their own right, given the interaction between the two policies, the question can be raised as to whether the new arrangement can deliver a desirable policy mix. The study notes that the framework does not wholly preclude policy coordination. Both fiscal and monetary policy have an explicit and appropriate medium-term focus under current policy rules. The absence of attempts to fine-tune limits the need for day-to-day policy coordination. Also, the treasury has publicly emphasized that fiscal policy should support monetary policy in promoting stability.

Nevertheless, several features of the new regime could impair effective policy coordination:

• The nature of the “policy game” is not yet clear. On the one hand, the yearly announcement of the fiscal budget and the inflation target by the chancellor of the exchequer and the more frequent decisions on monetary policy tend to put the government in a leading position. On the other hand, the inflation target is unlikely to be adjusted frequently and, given its independence, the central bank could decide to ignore the government’s preferences.

• The bank and the treasury may develop different views of economic development and, therefore, of future inflation, thus possibly ending up working at cross purposes.

• The new rules for fiscal policy are likely to affect the degree of automatic fiscal stabilization. Given that fiscal policy tends to affect aggregate output more rapidly than changes in official interest rates, this uncertainty complicates forward-looking monetary policy.

• Policymakers’ strategies under the current framework are still unclear. In particular, considerable uncertainty remains on the different policy stances of the members of the Monetary Policy Committee and on their strategic interaction.

Given the historical inflation bias in the United Kingdom and the of ten poor policy coordination, the study suggests that the potential drawbacks of decoupling monetary from fiscal policy should not be overrated. Some of the uncertainties are likely to be resolved over time as policy practices are established based on the new framework and policymakers gain understanding of each other’s strategies. Also, given the record so far on policy coordination, the new, partly rules-based framework is likely to be an improvement in promoting overall macroeconomic stability. Still, adequate exchange of information between the chancellor and the Bank of England—including, for example, the advanced announcement of tax and expenditure measures that are likely to be included in the budget—would clearly help policy coordination. Moreover, a more transparent approach to inflation forecasting by the bank and its likely future interest rate policies would help the fiscal authorities determine the extent to which fiscal policy needs to be used for macroeconomic management.

Conclusions

Inflation targeting combined with operational independence of the central bank, as exists in the United Kingdom, is noteworthy, the IMF study observes, in that it incorporates features that are in line with evolving views on best practices and have, therefore, not been subject to empirical scrutiny. After evaluating the U.K. experience during its first year and a half, the study concludes that despite some potential weaknesses, it provides a suitable framework for a focused and credible monetary policy that is effective in reducing the inflationary bias in policymaking.

The potential drawbacks of decoupling monetary from fiscal policy should not be overrated.