Monetary Policy and Inflation of UK - Term Paper Example

MONETARY POLICY AND INFLATION IN THE UK Introduction From the contemporary macroeconomic perspective, inflation targeting (IT) is considered to be one of the most important aspects of the monetary policy. It is evident that although different IT regimes consider price stability as their primary objective, without credibility the policy objective in itself does not guarantee a low and stable inflation rate. Credibility of a central bank is achieved when intentions of this financial institution become guiding principles of economic participants’ understanding and expectation of macroeconomic trend. The United Kingdom, like many other regimes that adopted inflation targeting, try to achieve credibility through price stability as an explicit monetary policy objective, an inflation rate as policy target, and an interest rate as policy instrument. This particular paper aims to discuss and analyze the model of UK monetary policy and its continuous impact on current inflation. United Kingdom: Brief Economy Background The United Kingdom (UK) is a leading trading power and financial center, is one of the quintet of trillion dollar economies of Western Europe. Britain's economy enjoyed a period of expansion on its economic growth till early 2008, after which, the global financial crisis hit the economy hard and the economy took this brunt in a downward slope, resulting in sharp decline of home prices, high consumer debt, and the global economic slowdown compounded Britain’s economic problems, pushing the economy into recession in the latter half of 2008 and prompting the United kingdom bank and the government to implement a number of measures to stimulate the economy and stabilize the financial markets; these include nationalizing parts of the banking system, cutting taxes, suspending public sector borrowing rules, and moving forward public spending on capital projects. Patterns of the United Kingdom Monetary Policy From the economic history perspective, the U.K. experience offers a rich history of various monetary policy regimes. Bernanke, et al. (1999) provide an excellent review of international experiences with various policy regimes. For instance, the U.K. had targeted a broad range of indicators, including money supply M0 and nominal income until the late 1980s. The monetary policy over that period had not proved successful because, as Bernanke, et al. (1999) explains, monetary targeting was not pursued seriously and because the link between monetary aggregates and ination had become weak. In 1992, after U.K. abandoned the European Exchange Rate Mechanism (ERM) membership and announced infation targeting (IT). Many authors, including Bernanke, et al. (1999) document that ination targeting has proved successful in the U.K., based on levels of inflation and its variation. Within the IT regimes, the U.K. adopted a few different targets. First, it targeted with the 1% - 4% range for ination as measured by the retail price index (RPI). Second, it targeted asymmetrically under 2.5%, but within the same 1% - 4% range (Bernanke, et al 1999). Third, it implemented a symmetric targeting around 2.5% and almost simulteneously a new monetary policy committee (MPC) started making decisions on interest rates. Finally, in 2003, the official definition of inflation changed from retail price index inflation to harmonized consumer price inflation and the target shifted to 2.0%. The graph below reveals the dynamics of UK inflation rate and how various monetary police approaches impacted this dynamics. Since the eruption of the recent credit crisis, it is useful to ask is whether IT has retained its effectiveness. Indeed, ination and ination expectations have dropped into negative terrotory in the U.K. during the crisis. While there seems to be a consensus that there is no “going back”, that is IT will not be abolished, a new, more realistic question is how to augment the IT policy. IMF (2009) attempts to answer this question by emphasizing the importance of the financial system for the economy. Thus, central banks should now consider financial stability among their primary targets. Indeed, the purpose of the Bank of England is to promoting and maintains monetary and financial stability as its contribution to a healthy economy. Monetary stability means stable prices, low inflation and confidence in the currency. Stable prices are defined by the Government’s inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (Bank of England, 2010). The Monetary policy committee sets the interest rate based on the conditions of domestic monetary market, foreign exchange market, production market and labor market (Bank of England, 2010). To curb inflation, the monetary policy committee primary tool is the setting of interest rates. The committees set the official interest rate to keep the inflation at targeted levels. Considering the inflation rate of UK and it annual rate of inflation last September the CPI index fell to 1.1 % Since then it has risen to 3.7% in April, the highest it’s been since November 2008. The Bank of England’s Monetary Policy Committee (MPC) is charged by the Government to maintain price stability, defined as keeping annual inflation at 2% (as measured by the CPI). The MPC believes that the recent rise in inflation above the 2% target is largely due to three factors: (1) The restoration of the standard rate of VAT to 17.5% from 1 January 2010. In November 2008, the previous Government announced that the standard rate of VAT was to be lowered from 17.5% to 15% for 13 months. This resulted in increased price volatility. The restoration of the 17.5% rate in January 2010, for instance, is a major factor behind the increase in inflation this year. Assuming there are no further changes to the VAT rate, we can expect downward pressure on the annual rate of inflation from January 2011 as this year’s VAT increase drops out of annual comparison in the CPI data. (Daniel et al, 2004) (2) The increasing cost of oil. The rising price of petrol as oil prices have doubled since early 2009 has been another prominent cause of higher inflation. The transport component (including fuel costs) of the CPI contributed nearly half of April’s overall 3.7% increase in the CPI. (et al Daniel, 2004) (3) Depreciation of the pound. There was sharp depreciation of the pound value in 2007 and 2008 and this effect is still seen on inflation due higher import costs. According to the MPC’s May Inflation Report, which states that even excluding fuels, the price of imports was 15% higher in Q4 2009 than in Q4 2007; this was not the case when compared a year ago The future path of import prices is highly uncertain and, in addition to exchange rate movements, will depend on companies’ pricing decisions. (Daniel, 2004) Inflation in UK currently stopped at 3.1%, which is 0.1% above government’s upper limit of 3.0 percent, with unemployment levels currently at 7.8 percent, continues to add downside pressures on spending. This inflation affects in retail sales, pharmacies, sporting goods and on other fields also. The latest statement released from the BOE cited the Governor’s aims to push forward the monetary policy in the direction of stimulating growth rather than focusing on inflation that threaten the recovery in the country. Therefore, it is highly predicted that the bank will preserve its dovish stance for the remainder of this year, before starting to hike interest rates and withdraw stimulus measures from the market by early 2011. Conclusion From the critical perspective, if inflation occurs in any economic regime, there are likely multiple reasons for this trend. In the context of the United Kingdom, the reasons are embedded in the restoration of standard VAT rate, increasing cost of oil, and depreciation of the pound. Moreover, evident price increase of particular commodities globally (wheat, corn, and wood) gradually and inevitably increase retail prices of products in the final market. That is the main reason to have a target inflation band based on the consumer price index (CPI) or its equivalent as a target measure. Economists (Bernanke and Mishkin, 1997) advocate the use of a widely understood inflation measure as the policy target to enhance credibility and transparency of monetary policy. A simple and well-known indicator is better understood by the public and improves private sector planning. Using the simple indicator also helps the public to hold the central bank accountable when the targets are missed. In contemporary context, central banks require well developed financial markets and foreign exchange markets to influence the price level. Inflation targeting regime in the United Kingdom, for alternative scenario, can use the short-run rediscount rate as the policy rate. A change in the policy rate affects the economy through various transmission mechanisms. For instance, a fall in the policy rate generally affects interest rates in the financial markets to fall, which stimulate consumption in the real economy. Economists (Mishkin, 2004) provide various channels (the interest rate channel, exchange rate channel, credit channel) by which the policy rate impacts the real economy. REFERENCES Bernanke B., Thomas L., Mishkin F., and Posen A. (1999). Inflation Targeting: Lessons from the International Experience. Princeton University Press. Bernanke, B. S. , and Mishkin, F. S. (1997). Inflation Targeting: A New Framework for Monetary Policy? Journal of Economic Perspectives, Vol. 11, Number 2 - Spring: 97-116. International Monetary Fund. (2009). Global Financial Stability Report, World Economic and Financial Surveys (Washington, October). Mishkin, F. S. (2004). Can Inflation Targeting Work in Emerging Market Countries? NBER Working Paper Series 10646, July. Read More