Inflation Targeting Policy for Bank of England - Essay Example

Why Bank of England Adopted a Policy of Inflation Targeting in 1992 And the Effects the Policy has had Introduction The purpose of this study is to throw some light upon the functioning of the Central Bank, The Bank of England. The study tries to go in depth and have a look at the factors that are directly responsible for the ever changing policies of the Bank. The study tries to bring to light the whole regulation and the functioning of the Bank and the way it deals with various economic pressures, like Inflation, Deflation and Interest Rates. We will also analyze the factors which were responsible for a change in monetary policy in 1992, and the stance of Bank of England on inflation. Any government has the power to regulate the economy of the country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. Government of England has entrusted the job of determining the monetary policy, in the hands of Bank of England. Bank of England looks into many other big issues. One of the most important issues is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Bank comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government’s economic objectives of growth and employment. Price stability is taken care of, by the Government’s usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. Chancellor of the Exchequer announces the Government’s inflation target every year in the annual Budget statement. Though The 1998 Bank of England Act enables it to set interest rates independently, however, The Bank does hold accountability to the parliament and the wider public, which can not be refrained from. The legislation provides the government the power to instruct the bank on the interest rates issues for a limited period of time during emergency, for the sake of national interests. (How Monetary Policy Works) The inflation target of 2% depicts the target in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The government’s intention is definitely not to achieve the lowest possible inflation rate, as a low inflation is supposed to be equally bad as a high one and for that matter inflation below the target of 2% is judged to be as worse as inflation above the predefined target. The inflation target is therefore very symmetrical. (How Monetary Policy Works) If the Bank misses the target just by a margin of more than 1 percentage points on any side, be it up or down, the Governor of the Bank is required to write an open letter to the Chancellor explaining all the reasons as to why it happened and why inflation increased or fell to such an extent and what are the proposals to ensure that inflation comes back to the target and is retained, however, A target of 2% does in no way mean that inflation will be held at this rate constantly. That would be neither possible nor in any way desirable. Interest rates would be changing all the times, causing unnecessary volatility in the economy. Even then it would neither be possible nor feasible to keep inflation at any predetermined level, say 2% in each and every month continuously. Instead, the committee aims to set interest rates so that inflation can be brought back to target within a reasonable and imaginable span of time without creating undue instability and volatility in the economy. The Committee has its own way of functioning and it entrusts the job of taking all interest rate decision with a nine member committee. The committee’s predominantly focuses on meeting the inflation target by setting an interest rate. (How Monetary Policy Works) Role of Government in Regulating Inflation The Bank of England has a monetary policy and it uses the same to regulate mechanism of the economy. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. The Inflationary Scenario of 1992 The UK has had inflation targeting ever since 1992. In early 1970s it was believed that there was a stable trade off between unemployment and inflation, but the belief proved to be mistaken, and the targets/instruments approach to economic policy, applied in this way, led to a combination of rising inflation coupled with rising unemployment, as a result, inflation exceeded 25% in 1975. The scenario made it pretty clear to the economists that a low inflation was the key to economic growth and stability and so it was assigned a top priority among the economic objectives. To bring inflation down to the current levels, there were a host of techniques used, like Monetary Targets. Monetary Targets were adopted in the late 70s and the early 80s and they were primarily responsible for the fall in inflation from over 20 per cent to below 10 per cent, but soon it became pretty clear that monetary targets were not a perfect guide to monetary policy. From the mid 80s, exchange rate targets came into existence. For one year, in 1987-88, the pound, which was in strong demand, was prevented from appreciating above a particular level by purchasing foreign exchange and reducing in interest rates. This policy was predominantly based on the belief that if the sterling/ deutschemarks exchange rate could be stabilized, then in the long run UK inflation would converge to the level prevailing in Germany. During 1987-88, however, the economy was experiencing an upswing, with domestic demand growing at a scorching pace coupled with house prices increasing sharply, however, Monetary policy remained a bit pre-occupied with stabilizing the exchange rate, and so acted procyclically by aggravating the strength of domestic demand, which resulted in a steep rise in house prices. (INFLATION TARGETING IN THE UNITED KINGDOM (1992-2000)) At a point in 1990 when inflation as well as interest rates was at their highest, the country joined the European Exchange Rate Mechanism, consequently, inflation fell rapidly, because the economy moved into recession after the recently concluded boom, and also as the membership of the ERM helped to bring down inflationary expectations in the country. Interest rates followed suit, but they did not fall below comparable German interest rates, as it was by then very clear that international investors would prefer to hold Deutschemarks instead of sterling if the interest rates were equal. So, without an interest rate premium over the DM, sterling did not stay in the ERM exchange rate band. German interest rates rose in 1990, which meant that the scope for UK interest rates to fall became lesser. The economy being in a recession, there was a widespread dilemma for monetary policy that financial market participants easily identified, consequently, sterling was forced out of the ERM in September 1992. (INFLATION TARGETING IN THE UNITED KINGDOM (1992-2000)) The UK’s departure from the ERM in 1992 was a shock. It did enormous damage to the public credibility of the conservative government and also the credibility of the monetary policy. Although short-term interest rates fell by 400 basis points in the five months, bond yields increased, bringing to light, the fact that longer term inflationary expectations had risen up by over 1% and hence there was an urgent need for a new monetary policy strategy to shape up and rebuild the credibility of monetary policy and also fight to bring down inflationary expectations. (INFLATION TARGETING IN THE UNITED KINGDOM (1992-2000)) Works Cited “How Monetary Policy Works” bankofengland. 06Apr.2007. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm “INFLATION TARGETING IN THE UNITED KINGDOM (1992-2000)” tcmb. 06 Apr.2007 http://www.tcmb.gov.tr/yeni/evds/yayin/kitaplar/enf_kitap/3-William_Allen.pdf Read More