How Inflation Targeting Operates in the UK and Critically Evaluates the Benefits of Inflation Targeting - Essay Example

?How inflation targeting operates in the UK and critically evaluates the benefits of inflation targeting College How inflation targeting in the UK operates Inflation targeting is a move by the central bank to set a specific inflation target which will then be achieved by either raising interest rates or lowering it. Interest rate is inversely related to inflation. So when the current inflation is high above the target, the central bank will respond by raising the interest rate in order to put a downward pressure on inflation and when the current inflation is way below the target the central bank will lower interest rate in order to put an upward pressure on the inflation (Carol 2002). Inflation is all about price stability and it has been agreed by the economist that a rate of between (0-3) percent is the good enough rate fro the economy. With stable prices at that rate, consumer confidence is raised hence propelling the economy, if the consumer confidence is lower, then the economy will be stuck (Ben 2003). Inflation can only be made success through central banks making price stability its primary objective through strong institutional commitment to attaining that. United Kingdom was not the first country to introduce the inflation instead there are countries like Canada which did it ahead of them. Many countries over time have followed suit to introduce the inflation targeting within their economies with many others looking for technical assistance to help them introduce it (Richard 2005). Japan is one of the few who have not adopted it yet because of its well developed economy with rather stable inflation rate. UK inflation is therefore currently more stable in comparison with the past performance. UK quit ERM in 1992 due to rising tension between having to follow a tight policy framework in order to maintain existing exchange rate and the other option of having to cut the domestic downfall by taking down interest rates it (Richard 2005). The central bankers are very concerned with inflation drifting away from the target and equally concerned with the deviation of the output from the potential (Mervyn 2005). It ensures that the inflation does not sway way far from the target because that will bring disaster to the economy. With such big concern about inflation and well versed with knowledge of the trade-off between output and the inflation, the policy maker will then fix interest rates through adjustments informed by the knowledge on relative demand to supply and inflation. The central bank then set in the money markets the nominal interest rate and since prices of goods are somehow rigid then there will be movements around the real rate that always stand in absence of such moves by the central bank (Mervyn 2005). Due to these sticky prices, if a crisis hit the economy, it slips inflation away from the target and central bank can not quickly take it back to the track instead it has to take the longer old route by factoring in the monetary policy on what is the most. This older route will include having to factor in the bigger things that include having to go over the expected demands and supply and he pressure it will have on one another, that is to say the productive capacity of the economy and its cost implication as well as whether the economy is still on the track in relative to the expected inflation (Paul 1998). After all that considerations the central bank will then design a way to bring quickly inflation back to target with consideration of the impact it will have on the output. It will then have to decide on whether to aggregate demand should be stimulated or not and whether to be neutral. With all that there are unobservable effects of inflation on unemployment which it raises, the interest rates and growth of the economy through supply. The monetary policy committee (MPC) targets inflation by setting interest rates. When a shock hit the economy the committee action is not felt immediately. The results of adjustments in interest rates could yield tangible results after even two years and therefore the committee has to be forward looking (Paul 2006). The committee meets every month to set interest rate. The week prior to that, the committee has to gather information from a variety of sources, mainly the banks on the state of the economy. They then have to compare and put together with the reports of the previous month before coming to set interest rate. The committees take into account the fact that if demand rises so rapidly the inflation will certainly too rises. And if demand fall to a point that people start loosing jobs and business close, there will be a reverse effect and inflation will fall. The MPC will alter interest rate in order to reach a point balance between supply and the demand for the economy (Paul 1998). When interest rates are lowered people will save less and start spending and investing in the economy by borrowing. Sterling will however become less attractive as its value will fall and export will start to rise but in long run inflation will again rise because imported goods will become expensive. In the UK inflation targeting have also been successes by communicate efficiently and effectively to the people and the public. The central bank make information readily available too the public and often publish its reports. It also communicates efficiently with the government so that everything is kept in balance. The central bank of England have but some constraints on the chancellor to make its decision based on the real movements or shifts in the economic rather than such moves being politically motivated (Paul 1998). The labor government when it came into power under leadership of Gordon brown hand over the responsibility of inflation targeting to the bank of England and more precisely it handed over it to monetary policy committee and the inflation targeting become solely the responsibility of the chancellor. That move by the government raise the credibility issue within the institution and long term inflation targets begin to be realized. The central bank target has always been 2.5% over time. The government is not in anyway able to set a output level very high and this have saved the running of the institution from political manipulation that seek to manipulate interest for political reasons (Paul 1998). The central bank have also been shielded from potential pressure to opt for a more accommodative monetary policy in the short run because this will not work well together with effort to keep inflation to target. The other policy within central bank is that if the inflation drift for over a point from the targeted the Governor should take the responsibility of having to write to the chancellor to explain why it have been so and also, in its writing he should include the proposed solutions and be able to explain the consistency between the proposed solutions and the governments general policies. It is also stressed that such writing of letters should not be a signal of failure but rather an explanation to the public as to why the inflation have deviated from the target. The bank of England’s (MPC) comprise of five members an ex officio and four externals. The external members are mainly aimed in order to inject fresh ideas into the bank. These members are appointed by the chancellor and while appointing the chancellor ensures that these members are drawn from the elites who at some point in their lives ought to have been economist or having worked in a financial institutions. In the committee the debate is very healthy under the chairmanship of the governor (Luca 2005). By so doing the governor can not impose its views on the members of the committee but enable a healthy debate on the future of the institution. If the members disagree to a larger extent it will be to our judgment that the future is not definitely certain and something has to be done. Unlike other central banks of which in the quarterly forecast whatever it is injected into policy formulation is drawn from staffs in England it is the work of the committee that is published in quarterly projections (Luca 2005). The committees hold series of meetings with the staffs collect their version of their story and incorporate it into their findings they will then have other several meetings and their final projection after their own findings together with those of the staff are incorporated the final report is weighed against that of the outsiders and final projection is drawn. The quarterly forecast is such a useful step because it makes it possible for various different data to be incorporated together. In this quarterly forecast also the current fixed interest rate is communicated to the outside world together with the inflation target for the central bank. Inflation targeting has far reaching benefits. Its advantages are drawn from its two parts approach to reaching the inflation target. The two policies are the constrained discretion and the other one is the communicating strategy (Luca 2005). The two explain to the public their policy helping boost public confidence and also raising the credibility of the institution. This two policy strategy keeps price stable hence preventing the inflation from rising. The latter works very well to stabilize the output and employment as well. Therefore a well formulated inflation-targeting strategy will help in terms of employment and output as well as inflation coming down to accepted rate (Luca 2005). With the introduction of inflation targeting in the UK the size of business-cycle often fluctuating has drastically dropped to a record low. These results are quite encouraging because it has been consistent over time and this give the confidence that inflation targeting is really bearing fruits. After the introduction of inflation targeting the inflation volatility have dropped by great margin. In comparison between the current regime and the previous ones prior to 1992 it is very clear that the volatility in the current regime is almost by half in comparison to the previous regime. Inflation targeting has also brought stability in the UK economy. The inflation has been stable over time since the introduction and prices have quite remained stable. Another key feature of inflation targeting is that there is a lot of transparency in terms of policy related to inflation targeting and this have made central bank more accountable to the public as opposed to the previous regimes where central bank were barely accountable tom the public (Marie 2009). Inflation targeting has proven successful in countries that adopted it. Inflation targeting countries have been able to achieve the inflation that is lower than what could have been achieved without inflation targeting. Inflation targeting has also toughened central banks to be independent and central bank is no longer subject to political gimmicks and other variables outside the financial system (Marie 2009). Monetary policy has also been now more focused on inflation more than before. It has been so due to introduction of inflation targeting. The other benefit of inflation targeting is that it has made the monetary policy focus on the domestic economy and being able to respond to shocks within the domestic economy so as to keep things at the stable condition by suggesting ways of bringing them back to normalcy (Marie 2009). The inflation targeting has also the potential to reduce the possibility of the central bank slipping into time inconsistency trap. It has managed to do so by shielding the central bank from the political pressure to adopt expansionary policies. It has shifted the political debates to focus solely on what the central bank can do (Luca 2005). In conclusion Britain monetary policy has gone through changes since post-war period. And over time with institutional reforms and changes and lessons from other countries Britain have been able to come up with a policy that have brought stability to its financial sector. The two main strategies are the central bank dependency and the inflation target strategy. Central bank dependency has brought a lot of improvement and raise credibility test within the central bank. Inflation target on the other hand have brought inflation into stability. There will be new challenges emerging in the financial markets and anywhere within the economic sphere so the strategy being applied now to tackle the challenges will have to evolve overtime. References Ben B, ‘A perspective on inflation targeting’ Remarks by Governor Ben S. Bernanke at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C. March 25, 2003 http://www.federalreserve.gov/boarddocs/speeches/2003/20030325/. Carol S. C, 2002, Statistical Implications of Inflation Targeting: Getting the Right Numbers and Getting the Numbers Right, International Monetary Fund, New York Charles B, ‘Inflation targeting: the UK experience’, Speech by Charles Bean, Chief Economist and member of the Monetary Policy Committee, given at the annual meeting of the German Economic Association, Zurich, 1-3 October 2003 http://www.bankofengland.co.uk/publications/speeches/2003/speech203.pdf. Frederic M, ‘Inflation targeting’ http://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/01ENCYC.pdf#search='mishkin%20inflation%20targeting'. Luca B, ‘The inflation targeting framework from an historical perspective’, Bank of England Quarterly Bulletin, summer 2005 http://www.bankofengland.co.uk/publications/quarterlybulletin/qb050203.pdf. Marie D, 2009, Are Inflation Targets Good Inflation Forecasts? A Reprint from "Economic Perspectives", DIANE Publishing, New York Mervyn K, ‘Monetary Policy: Practice ahead of theory’, Mais lecture by the Governor of the Bank of England, 2005 http://www.bankofengland.co.uk/publications/speeches/2005/speech245.pdf. Paul R. M, 1998, Inflation Targeting as a Framework for Monetary Policy (EPub), International Monetary Fund, New York. Paul T, ‘Reflections on operating inflation targeting’, Speech by Paul Tucker, Executive Director for Markets and a member of the Monetary Policy Committee, delivered at the Chicago Graduate School of Business on 25 May 2006 http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060209.pdf. Richard L, ‘Inside the MPC’, Bank of England Quarterly Bulletin, spring 2005 http://www.bankofengland.co.uk/publications/quarterlybulletin/qb050105.pdf. Read More