Inflation and the Monetary Policy Committee - Essay Example

Inflation 17th November Inflation Introduction: Following the post-war period the role of the monetary policy in England was marginal. Weightage was given to the popular Keynesian model and Fiscal Policy was the chief regulator of microeconomic instability. At that time Interest rates were set very low to encourage investments and credit controls ensured secure and well-backed consumer borrowing. In cases where demand increased tremendously and threatened to augment inflation rates and cause large balance of payments deficits-income, instead of monetary policy, was used as the instrument to keep inflationary pressures in check. In case proportionately controlled incomes failed to bring about changes in demand, devaluation of money was used as a means of returning to efficiency. However, the failure of the Bretton Woods model led to a period of higher inflation caused by increases in additional demand. (Charles Bean, 2003, pp 1-4) The Bretton Woods model failed for three main reasons. Firstly, the gold standard exchange endangered the U.S. economy with a convertible crisis and the U.S. took stringent measures, which in effect made exchange even more difficult. Secondly, the adjustable peg system failed to work in the wake of capital mobility, which cause even small changes in parities to become large costs. Thirdly, the countries with a trade surplus were becoming progressively reluctant to adjust. The first world countries were uninterested in revaluating their currencies every time the U.S. had a trade imbalance. This resulted in the waning of the American economic power relative to European countries and Japan. The G10 lost its power and the stage was set for a more individualistic and decentralized system for stabilizing macroeconomic conditions. (Michael D. Bordo, 1993) In the 1980’s all monetary targets were unsuccessful because it was very difficult to predict if the policy goals would reap the intermediate or economic targets. So an inflation target was proposed- and the system converted in 1992. The target measure chosen was the Retail Price Index (RPI), which omitted mortgage payments. The target was set at 1-4% with the expectation that it would come to be so near the end of the parliaments term at office. The adoption of the system of inflation targeting was followed closely by utilitarian systems whereby the Chancellor of the Exchequer and the Governor of the Bank of England met together with their advisory teams and the minutes of the meeting were published in the Bank’s Inflation Report, which analyzed all inflationary trends with the estimated margin of errors and insight into two years into the future. How England has implemented the system of inflation targeting: In contrast to many countries, which use inflation targeting, England has a point inflation target of 2% on the RPI so as to minimize parliamentary debates over the rate. Since inflation targeting, the rates have been more or less in line with the mark especially after the bank gained independence. The independence came about in 1997 when the Chancellor Gordon Brown, gave operational authority of the inflation target to the Bank of England-more specifically the Monetary Policy Committee- in order to give credibility gain to the long-term inflation expectations. These legislative changes were then included in the Bank of England Act-1998. (Charles Bean, 2003, pp 11-13) The Monetary Policy Committee (MPC): The grander view of the monetary policy claims a stable rate of inflation over the long term. Decisions concerning the level of inflation and subsequently that of interest rates are made by the Monetary Policy Committee of England, which affects the lives of savers, mortgage bearers, and the purchasing power of all salary earners. The committee is composed of nine members. It is headed by the Governor of the Bank of England and includes two Deputy Governors, Chief Economists and Markets Director. Apart from these five banks officials it comprises of four other external experts who are appointed for three years by the Chancellor of the Exchequer. The Chancellor of the Exchequer sets the committee’s objectives and in addition to its goals regarding inflation the committee also has to make sure that it aids growth an employment. If the committee is unable to meet the inflation target by 1% either upward or downward in direction than the Governor must write to the Chancellor and explain what policy measures the MPC will take. (Richard Lambert, pp 56-65) The MPC meets every Wednesday or Thursday after the first Monday of the new month but before the MPC meeting a pre-MPC meeting is held. The pre-MPC meeting is attended by all the committees’ members as well as by all the regional agents of the Bank of England. Its purpose is to gather economic news, analysis and statistical developments in growth rates of the euro and wages. The agents meet all their contacts from large and small businesses across all industries and report back the findings to the pre-MPC meeting. Before the MPC meeting the Chief Economist devises a basic framework for the points to be discussed in the meeting. On the day of the meeting there are 14 members present in the MPC meeting-the nine members -4 senior bank staff who take minutes for the Bank Of England’s publication-the Inflation report; also included in the meeting is the Treasurer. In the meeting the members discuss the previous months economic conditions, retail sales, the euro and export figures. On the subsequent day the committee’s members make separate brief presentations about what they deem as the most crucial economic insights, which are likely to affect inflation, and then they cast their votes. After the votes are given the committee then decides on the issues which they would like to know more about and which can be given to Agents so they can conduct industry research and bring the relevant information on which to base next months inflation target. Usually, the decision of the committee is covered by a minor press release. Before the minutes of the MPC meeting are published in the Inflation Report the MPC members as having covered all the important and necessary details approve them. Over the years, one thing has become apparent. That the MPC prefers small changes in inflation rates so that the high speculation would not lead to the imposition of high interest rates. (S. Bernanke, 2003) It must be noted that although the full information to the economic activity is easily available to the MPC, it is extremely difficult to make decisions because of the time lag factor, which can cause policy results to take a minimum of two years to show material effects on the economy. If the economy carries news that for e.g. consumer confidence is fading and there is a drop in demand then interest rates may have to be cut to revive the weakening demand. The policy maker has the choice of waiting and calculating but by then the change on actual demand may be very big and it may deviate considerably from potential demand together with the mismatch of the interest target. Here the policy maker has to face a trade off based on his/her projection of the economy. (Robert Lambert, pp 56-65) Benefits of inflation targeting: The success of the inflation targeting method of monetary policy targeting at prices can only be evaluated once its effects on the economy are compared with the effects of previous economic regimes. The data from the study by Luca Benati- The inflation-targeting framework from a historical perspective- show that the GDP, expenditure and business cycle volatility has been considerably lower post-1992. Secondly, the volatility of inflation between inflation targeting and previous regimes is markedly lower. For e.g. based on the yearly GDP calculations, volatility has been 1.5 times lower than under Bretton Woods, 0.2 times lower than in 1972-1992, and 0.25 times lower than under the gold standard. Surprisingly, the volatility of inflation over the inter-war periods was only a minutely different from under the current model. (Luca Benati, pp 160-166) Another very important factor of measuring stability is the Phillips correlation- the relationship between unemployment inflation. The period from 1972-1992 witnessed a sharp contrast in the Phillips relationship, which had a slope of -2.3% indicating that a 1% decline in inflation would increase employment by 2.3%. During the gold standard period England faced constantly fluctuating employment but the arrangement between the components of the Phillips curve was relatively stagnant. In contrast the current regime has experienced the most stable inflation-employment tradeoff in recorded history together with a standard deviation of error of less than half under other regimes. (Paul tucker, 2006, pp 215-222) Finally, the study concludes that high persisting inflationary pressures have been exclusion and that mapping of the float of the sterling shows that there is a mildly negative correlation between RPI/GDP and inflation and that since the possibility of otherwise is only 5% it is a given that even if inflation rises then it will not stay high for long. In comparison the period from 1972-1992 shows a very extreme and insistent inflationary trend. (Paul tucker, 2006, pp 215-222) In addition, historical data under inflation targeting shows that although there is no correlation between inflation and output, there is a tradeoff between the volatility of inflation and the volatility of output. The assessment of the movement of these volatilities before and after the change in monetary policy in 1992 shows that the volatility post 1992 is considerably lower even though there have been many severe patterns of global economic shocks as well as shocks that were felt due to the association with the EU. (Mervyn King, 2005, p 15) Conclusion Britain’s monetary policy has gone many revolutionary changes since the post war period, but the current system of inflation targeting followed by institutional changes, Bank of England’s independence and concentration on the tools of the monetary policy rather than fiscal policy to govern the economy has led to a level of stability which seemed impossible in the years of 1972-1992. Over the years inflation targeting has allowed the Bank of England to devise a monetary policy that does not have to depend upon the constancy between money and inflation but rather the inclusion of all economic data. It has allowed even greater economic strength because the transparency of this tool aids public expectations to stay afloat. Also, in its assessment with the exchange rate peg, inflation targeting has allowed the monetary policy to concentrate on domestic matters and respond to domestic shocks. In keeping with this the policy concentrates on what the Bank of England can do-create price stability-and not what it cannot do- stabilize employment, encourage growth etc. Over the past decades this feature has helped the Central Bank to avoid the time inconsistency trap and allow the smooth functionality of a specific inflation target to remain. (Frederick S. Mishkin, 2001, pp 2-3) References: Charles Bean. (2003). Inflation Targeting: The UK Experience. N.p n.d Web 17th November 2012. Retrieved from http://www.bankofengland.co.uk/publications/Documents/speeches/2003/speech203.pdf Michael D. Bordo. (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. National Bureu of Economic Research. N.p n.d Web 17th November 2012 Retrieved from http://www.nber.org/chapters/c6865.pdf Richard Lambert. Inside the MPC. N.p n.d Web 17th November 2012. Retrieved from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb050105.pdf Ben S. Bernanke. 2003. National Association of Business Economists. N.p n.d Web 17th November 2012. Retrieved from http://www.federalreserve.gov/boarddocs/speeches/2003/20030325/ Luca Benati. 2003. The inflation-targeting framework from a historical perspective. N.p n.d Web 17th November 2012. Retrieved from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb050203.pdf Paul Tucker. 2003. Reflections on operating inflation targeting. N.p n.d Web 17th November 2012. Retrieved from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb060209.pdf Mervyn King. 2005. Monetary Policy: Practice ahead of the theory. N.p n.d Web 17th November 2012. Retrieved from http://www.bankofengland.co.uk/publications/Documents/speeches/2005/speech245.pdf Frederick S. Mishkin. 2001. Inflation Targeting. N.p n.d Web 17th November 2012. Retrieved from http://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/01ENCYC.pdf#search=%27mishkin%20inflation%20targeting Read More