Monetary Policy Framework in the UK - Essay Example

Monetary policy framework in the UK Monetary Policy - An Introduction Monetary policy is an important aspect of overall macro-economic policy. Toinfluence economic conditions or to achieve economic objectives, monetary authorities employ various techniques. Monetary Policy can be broadly defined as "the deliberate effort by the Central Bank to influence economic activity by variations in the money supply, in availability of credit or in the interest rates consistent with the specific national objectives." Money is the major facilitator and motivator for all economic activity relating to consumption, production, exchange and distribution. Money serves as a medium of exchange, as a store of value, a standard for measuring values and a unit of account. The role of money is to serve as a medium of exchange, and it is the medium through which everything can be bought and sold. There are a number of guiding principles like price stability, exchange stability, full employment and maximum output and a high growth rate etc, in framing the Monetary Policy for an economy. The monetary policy of any country refers to the regulatory policy, whereby the monetary authority maintains its control over the supply of money for the realization of general economic objectives. This involves manipulating the supply of money, the level and structure of interest rates and other conditions affecting the availability of credit. However, in the context of developing economies monetary policy acquires a wider role and it has to be designed to meet the particular requirements of the economy. This involves not merely the restriction of credit expansion to curb inflation, but also the provision of adequate funds to meet the legitimate requirements of industry and trade and curbing the use of credit for unproductive and speculative purposes. The monetary policy of an economy operates through three important instruments, viz. the regulation of money supply, control over aggregate credit and the interest rate policy. Economic growth is dependent on mobilizing savings and directing them into productive channels. In this process, money supply can only play a limited role. However, the role establishes an important connection between money supply, output and price level (ICFAI Center for Management Research (ICMR)). These relationships cannot be ignored even if the primary concern of the government is mobilization of real factors that ultimately lead to economic growth. UK Monetary Policy regime A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices - inflation - reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money - the interest rate. In May 1997 the Government gave the Bank independence to set monetary policy by deciding the level of interest rates to meet the Government's inflation target - currently 2% (Bank of England). The 1998 Bank of England Act made the Bank independent to set interest rates. The Bank is accountable to parliament and the wider public. The legislation provides that if, in extreme circumstances, the national interest demands it, and the Government has the power to give instructions to the Bank on interest rates for a limited period (Bank of England). In the period from the floating of the exchange rate in June 1972 to the granting of operational independence to the Bank of England in May 1997, UK monetary policy went through several regimes. These included the period in the 1970s when monetary policy was considered subordinate to incomes policy as the government's primary weapon against inflation; an emphasis on monetary targeting in the late 1970s and early 1980s; moves from 1987 toward greater management of the exchange rate, culminating in the UK's membership of the Exchange Rate Mechanism (ERM) from 1990 to 1992; and inflation targeting from October 1992 (Nelson). A clear policy of targeting of domestic inflation was not announced in the UK until October 1992. Prior to this, monetary policy from 1976 until the mid-1980s was based on targeting monetary aggregates with the specific target sometimes changing, followed by a period 1987 to 1992 where it first shadowed the Deutsche Mark and then later joined the European Exchange Rate Mechanism. However, the announcement of inflation targeting in October 1992 marks a regime switch, which in principle affects both the persistence properties of inflation and the coefficients of a reduced form Phillips curve relationship (Sensier). The Monetary Policy Committee is the authorized body that deals with the design of the monetary policy of the Untied Kingdom. The MPC sets an interest rate it judges will enable the inflation target to be met. The Bank's Monetary Policy Committee (MPC) is made up of nine members - the Governor, the two Deputy Governors, the Bank's Chief Economist, the Executive Director for Markets and four external members appointed directly by the Chancellor. A specific inflation target is set by the Chancellor of the Exchequer which the Monetary Policy committee is required to meet at all times. The target is symmetric in the sense that being below target is just as bad as being above target. To hit the inflation target the committee focuses on a period between 12 months and 30 months into the future. The committee generates a forecast every three months, conditioning on market expectations of the Bank of England's official interest rate (the market curve). If this produces forecasts such that inflation has a relatively high probability of moving significantly above (below) target, then it tends to raise (lower) rates above (below) those implied by the market curve (Nickell). UK monetary policy was significantly relaxed during 2001 and so despite falling investment and a weakening world economy, domestic demand continued to expand steadily so that overall growth rates remained positive. The inflation performance in the United Kingdom Throughout the post-war period, the United Kingdom has experienced relatively high inflation. In the 1960s UK inflation averaged just fewer than 4 per cent per annum compared with an average for OECD countries of under 3 per cent. This gap widened in the 1970s and from 1973 to 1979 UK consumer prices increased on average by 15.6 per cent per annum - almost 6 percentage points higher than the OECD average and 11 percentage points higher than West Germany. By the mid-1980s, though there had been a tremendous cost - in lost output, capacity and jobs - in the early 1980s, the battle against inflation appeared to have been won. In the five years to 1988, UK inflation averaged 4.6 per cent, a performance which had last been achieved in the 1960s. The basic problem was that throughout the mid-1980s, domestic demand was allowed to grow much more strongly in the United Kingdom than in its competitors' countries. While this may have been compatible with low inflation as the economy recovered from recession, it could not be sustained without fuelling inflationary pressures. The direct cause of this fast demand growth was the coincidence of financial deregulation and an increased desire to borrow, which fuelled consumer demand, and a recovery in business investment. Nevertheless, it was the government's responsibility to take any possible corrective measures to handle such a situation of the economy, but the government of the United Kingdom failed in doing so. This could possibly be because of certain technical difficulties in controlling the economy. Financial deregulation distorted monetary indicators and meant that economic monetary policy was increasingly governed by judgment rather than reference to reliable indicators. Measurement errors also distorted the other indicators on which the judgment was based; in particular the national accounts statistics (D. M. Williams). Second, in the 1980s, the elimination of inflation was given a lower priority than other policies, such as tax cuts, privatization and reform of local government finance. This would not have been so damaging if decisions taken in pursuit of these policies had not added to inflationary pressures at the same time. The inflation target of 2% is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The remit is not to achieve the lowest possible inflation rate. Inflation below the target of 2% is judged to be just as bad as inflation above the target. The inflation target is therefore symmetrical. A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC's aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy. UK labor market institutions and practices resulted in wages being less responsive to the level of unemployment in the mid-1980s than in many other countries. More significantly, there is a pervasive inflationary psychology in the United Kingdom which is not present in countries with a better inflation record and with greater credibility attached to their anti-inflationary policies. Recent performance of Inflation in UK The UK has recently been enjoying some of the lowest inflation rates in decades; the government and others put this down to the calculated decisions of the independent Monetary Policy Committee (MPC) of the Bank of England, which was set up by the current Labour government in May 1997 (Tutor2U). Source: http://tutor2u.net/economics/content/topics/inflation/uk_inflation_record.htm UK inflation was lower than expected in January 2007, dropping to 2.7% from 3.0% in December of the same year. While inflation is expected to remain elevated in February and March, a big drop is likely in the second quarter and it is also expected that inflation would move well below target (2.0%) in the second half of the year. The risks are still weighted towards a further increase to 5.5%. The UK's inflation performance since the Bank of England became independent in 1997 has been very good. Over this period, headline inflation has averaged just 1.5% compared with 1.9% in the euro area. Last year's performance was less impressive, however, with UK inflation ending 2006 more than a percentage point above the euro area. Last year's jump in inflation was not caused by a significant increase in underlying inflation pressure. Indeed, much of the rise was due to a pickup in gas and electricity prices, the result of specific supply issues. This pushed domestic fuel prices up 30% over the course of 2006, adding almost a percentage point to headline inflation. Underlying inflation, excluding food and energy, was just 1.8% in December and eased back to 1.6% in January (D. K. Williams). Factors & Mechanisms aiding in the rise of the inflationary performance As discussed in the earlier paragraphs of this paper, price stability is one of the guiding factors in designing a monetary policy. Institutionalization of price stability is the major mechanism that would really help in improving the performance of the inflation. In this way the inflationary psychology can be fully squeezed out and a damaging resurgence of inflation can be avoided. The commitment to maintain the value of the pound against the low-inflation countries of the ERM would be one means of achieving better inflationary performance (D. M. Williams). Additionally, fiscal measures can also be taken to raise personal savings. A 'counter inflation' unit within government to ensure the full impact of policy changes on inflation and inflationary expectations is taken into account when major decisions are taken. The UK retail price index is reformed as one of the measures to maintain the rising inflationary performance. Continued decentralization and increased flexibility in public as well as private sector pay bargaining and further measures to improve the supply-side of the economy are certain other factors. Current inflation decisions According to the Monetary Policy committee, higher energy, food and import prices push inflation up sharply in the near term. Inflation then eases back to a little above the 2% target in the medium term, as the near-term rise in energy prices drops out of the twelve-month rate and capacity pressures moderate. A similar projection, which assumes that interest rates remain constant at 5.25%, shows the central projection for inflation settling below the target in the medium term The Committee also noted that slower demand growth, by reducing the pressure on capacity, was likely to be necessary to return inflation to the target in the medium term. Under market interest rates, the central projection for inflation was a little above the target in the medium term, while under constant interest rates, it was below the target. The Committee judged that a reduction of 0.25 percentage points in Bank Rate to 5.25% was necessary to meet the target for CPI inflation over the medium term (MCP). The tightening in credit conditions is expected to bear down on demand and inflation over time. But inflation is set to rise sharply in the near term, posing risks to the medium-term inflationary outlook if inflation expectations become de-anchored from the target (MCP). Conclusion The monetary policy regime in the UK over the years shows that there were many changes that were brought in the economy of the United Kingdom. The inflation performance in the United Kingdom economy was unstable for some years and the reasons or this instability was technical issues, failure to maintain price stability and many similar aspects. The recent inflationary changes that were brought in aim at handling the situation and retaining the performance of the inflation in the United Kingdom. Bibliography 1. (ICMR), ICFAI Center for Management Research. Commercial Banking. Hyderabad: ICFAI Center for Management Research, 2003. 2. -. Financial Management for Managers. Hyderabad: ICFAI Center for Management Research , 2003. 3. Bank of England. Bank of England. 28 February 2008 . 4. Bank, BHF. Fxstreet.com. 25 05 2007. 03 01 2008 . 5. Business Insights. The UK Retail Banking Market Outlook. London: Business Insights, 2003. 6. Center for Economic Policy Research. 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