Inflation Targeting in the United Kingdom

Diplomarbeit von Benjamin Viertel

Introduction:

‘(A)n internal standard, so regulated as to maintain stability in an index number of prices, is a difficult scientific innovation, never yet put into practice’.

Especially since the operational introduction as central bank monetary policy framework in the early 1990s in New Zealand, the United Kingdom (UK), Canada and Sweden, inflation targeting has gained both empirical and theoretical relevance as a monetary policy strategy.

In this paper I relate to inflation targeting theory and its framework in the UK. For that purpose I first regard the development of inflation targeting in respect to other monetary policy strategies in sections (2.2) and (2.3). I will answer the question what the actual target variable is and why one would want to have inflation being low and stable. Then there is some complexity because the development of inflation targeting has to be viewed in relation to paradigmatic debates between Monetarist and New-Keynesian insights. In the sections (2.4) and (2.4) I present the two fundamental views of how an inflation targeting framework should be modelled. By stating some equations from basic theoretical literature, I try to give a overview about the dfferent characteristics of that monetary policy strategy and how there is still controversy about the way of modelling. Chapter (3) is concerned with the operational framework in the UK, including statements to historical developments at the Bank of England in section (3.1). In particular, gaining of operational independence in setting interest rates—section (3.1.5)—was an important step for the Bank. The present monetary policy framework will be reviewed in section (3.2), in detail relating to the Bank’s publication policy—section (3.2.2)—and the inflation forecasting process—section (3.2.3).

The Bank of England’s model of the transmission mechanism is reviewed in section (3.3). This includes the interest rate setting process, the role of money and the relationship between inflation and inflation expectations. Finally, I discuss some economic effects that changed the British economy since the introduction of inflation targeting—section (3.4).

Table of Contents:

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Chapter 2.4.6, Asymmetric Preferences and Non-linear Taylor Rules:

The virtues of an interest-rate, or Taylor rule stem from its simplicity and its ability to serve either as an informative input or as a more decisive factor in the implementation of monetary policy. While empirical evidence from various countries indicates that Taylor rules are often able to capture the salient dynamics of the relevant short-term interest rate, it is frequently argued that simple linear rules may not be adequate to capture the complexities arising in the conduct of monetary policy. It is possible that a Taylor rule may not have a simple linear form, but instead is best described by a non-linear form. A growing body of research indicates that the likelihood of non-linearities in the conduct of monetary policy is considerably high. For example Blinder argues that it is not optimal for the central bank to contract demand in the event of small deviations of inflation from target. Instead, it should fight inflation when it is favourable to do so. Squeezing the last drop of above-target inflation out of the economy may be too costly because of a worsening trade-off between inflation and output at low levels of inflation. In addition, it may be that there are important asymmetries and non-linearities in the business cycle, which would require policy makers to condition the interest rate response of policy non- linearly on the output gap. Furthermore, the effects of monetary policy shocks do appear to be more profound in recessions than in expansions.

So, asymmetric objectives normally lead to non-linear reaction functions. Dolado , Maria-Dolores and Naveira, for example, provide evidence that the US Fed and several European central banks have in the past responded more aggressively to positive compared to negative deviations of inflation from its target. In other research, the increased sensitivity of the central bank to negative output gaps along in the presence of uncertainty regarding the state of the economy is considered by Cuckierman and Ruge-Murcia to be the driving forces of inflation bias. Non-linearities relating to the UK will be further discussed in section (3.4.4).84 A simple way of capturing non-linearities in policy behaviour is to estimate threshold models whereby the policy rule switches into a different regime whenever inflation breaches one or more thresholds. It may be, for example, that when inflation is in the neighbourhood of the target level, the authorities pursue a largely accommodating monetary policy, so that changes in the interest rate are more or less random since they are responding to random shocks to the economy. Once inflation rises above a given level, however, the central bank may be more aggressive in linking interest rate movements to the implicit policy rule, so that the Taylor rule best describes short-run interest rate behaviour above that level. Similarly, if inflation falls below a certain level this may generate fears of deflation and the authorities may again implement a Taylor rule - but not necessarily the same one that is employed when inflation is high. This would suggest a three-regime model.

Summary:

The last section gave an overview to the early development of inflation targeting. Taylor provides a reference path for nominal interest rates, with (observed rather than expected) output and inflation deviations from targets as feedback variables. McCallum offers a path for base money growth in consistency with hitting an (again observed) nominal GDP trajectory. They are really two sides of the same monetary coin - one defined in quantity space, the other in price space. So in principle they provide information which is complementary. The reference paths from these monetary rules serve as a consistency check on a forward-looking policy rule. Precisely because they are mechanical and based on observable variables, the rules can help to identify and quantify the discretionary input into such a rule.86 While non-linearities in the Taylor rule can be the result of either non-linearity in the macro-economic structure of an economy (the output-inflation trade-off ) or of asymmetry in the central bank’s preferences, it is quite likely that both of these features are present in the economy and interact to exacerbate the degree of non-linearity in the policy rule.

In the eyes of Svensson, there are some disadvantages related to simple instrument rules as they were discussed in this section. He states that there is no room for the introduction of other influences on the target variables. The fact that no central bank yet explicitly introduced such a simple instrument rule is voting against its existence as direct monetary policy rule in countries that persue inflation targeting as well as in countries with other monetary policy systems. He points out that Taylor itself proposed that there might be circumstances where deviations from the rule are useful.88 So there has been research in a further direction, called target rule models.