Effectiveness of inflation targeting regime in UK
When the bank project future inflation to be higher than the target rate, it raises the interest rate in order to bring down inflation. On the other hand where future inflation is expected to be below the target rate the bank is more likely to lower the interest rate.
However the relationship between interest rate and inflation rate is not direct. When interest rate is lowered the borrowing cost reduces and this induces the private sector and the household to increase borrowing. This in turn increases aggregate demand forcing prices of good and services to increase. On the other hand rise in interest rate discourage borrowing forcing the household and private investors to cut spending and consequently prices falls (Mishkin, 2001).
Inflation targeting was first adopted in New Zealand in 1990 and latter other countries such as the UK, Canada, Australia, Brazil, Ireland, Czech Republic and South Africa adopted the policy. However the implementation of the policy vary from one country to the other as some country such as the UK have adopted a single point estimate as their targeted rate while others use a range e.g. 2-3 as the targeted rate.
The major difference between inflation targeting regime and other monetary policy regime such as the exchange rate and monetary targeting is that while such policies target intermediate variables in an effort to provide price stability, inflation targeting involves targeting a forecasted value of inflation thus commonly referred to as inflation forecasting targeting (Bernanke, Thomas Mishkin, 1999).
Increased use of inflation targeting by developed and developing economy led to abandonment of managed or fixed exchange rate and provide a frame work for lowering inflation without hampering economic growth. In implementing and ensuring successful operation of inflation targeting regime the following condition should be fulfilled.
Lack of fiscal dominance or strong fiscal policy
Predictable capital inflow usually leads to successful inflation targeting
Strong financial institution such as security market, commercial banking and independent central bank. Lack of well developed financial market lead to limited monetary policy instrument and with limited instrument the central bankmonetary authority will have limited ability to fine tune policy.
The monetary policy transmission mechanism should be understood and predictable.
eliminating other policy objectives or nominal anchors that may lead to conflict in attaining inflation target ensuring transparency during implementation of monetary policy action and communicating the various action to the public
The bank of England
In UK the bank of England is responsible for implementation of inflation targeting. The two major role of the bank are financial stability and monetary stability. The bank gained statutory responsibility of setting official interest rate in 1997. Monetary stability mainly deals with ensuring that prices remain stable and people have confidence in currency. The bank ensures that economic growth is non inflationary. The currently monetary policy framework has outlined the price stability objective which is in two main elements
Annual inflation target as set out by the government
Commitment to open and accountable policy making
The bank of England decides the level of short term interest rate that will meet the target level of inflation rate which is currently 2 (king, 1997).
Setting of interest rate
The interest rate that the bank uses to meet inflation target is set by a special committee known as the monetary policy committee. The monetary policy committee consists of nine members, four appointed by the chancellor i.e. they are external members and the rest from the bank of England. The committee is chaired by the governor of the bank of England. The monetary policy committee meet twice per month and decision are made by voting on the basis of one man one vote. The treasury is also represented by one member at the meeting but he is not allowed to vote.
Once decision on interest rate is made, announcement is made on the following day at 12 noon. On the second week after the meeting a record of vote and minutes of the meeting are published. Inflation reports are published by the bank of England in each quarter. This report provides in detail the prevailing economic condition, expected economic growth and inflation rate agreed by monetary policy committee. Besides publishing of inflation report, the bank also publishes other material to increase understanding and awareness of it monetary policy functions.
The committee has to explain it action regularly to the treasury committee in parliament. Members of the committee also visit different region of the country in order to explain their policy decision and also to gather information about the economic situation from organizations and businesses.
How inflation targeting works
The monetary policy committee decides on an interest rate that will achieve a targeted inflation rate. This interest rate is used by the bank of England to lend to financial institution. This rate affects the setting of interest rate by building society, commercial banks and other financial institutions for their borrower and savers. Change of interest rate has also an impact on price of shares, bonds and other financial asset. The exchange rate is also affected by changes in interest rate and ultimately the business and consumer demand is affected.
When interest rate is reduced borrowing become more attractive and saving less attractive and the net effect will be an increase in aggregate spending. Assuming the Keynesian equation on national income
Y G C I (X-M)
Where Y national income (GDP)
G government spending
C household consumption
I private investment
X export
M import
Reduction of interest rate encourages the household and private investors to increase spending. The two being component of GDP causes an increase in national income. In a case where the economy is responsive to increase in aggregate demand i.e. the economy is not at full employment level increase in aggregate demand would not only create addition to output but would cause inflation as well. A trade-off would exist between changes in the level of output and employment and changes in the level of price (Mishkin, 2001).
On the other hand an increase in interest rate has the effect of reducing aggregate demand and price. This can be explained using the graph below
Aggregate demand and aggregate supply diagram
Price
AS P1 P2 AD1 AD2 Q2 Q1 quantity
Increase in interest rate leads to a decrease in aggregate demand from AD1 to AD2 which also forces output to drop from Q1 to Q2 and prices from P1 to P2 i.e. the level of employment at Q2 is lower than at Q1, associated with lower employment level is lower price level or some level of deflation.
The overall effect of monetary policy is more rapid when it is credible. There is always a time lag involved before change of interest rate affect saving and spending and ultimately changes in consumer price. It is not possible to be precise about the timing and size of these channels but the maximum effect on output is expected to be felt after one year while changes in consumer prices are expected after two years following changes in interest rate (bofinger, 2002).
The bank target an inflation of 2 which is expressed in term of annual rate of inflation based on consumer price index. The aim of the bank is not to achieve the lowest level of inflation, an inflation rate below the target rate of 2 is considered as bad as inflation rate above the target. Where the bank misses the target by more than 1 on either side e.g. when inflation of 1 or 3 is achieved the governor of the bank must write an open letter to the chancellor of exchequer explaining why the inflation rate has fallen or increased, how long the discrepancy is expected to persist and measures undertaken by monetary policy committee to steer inflation back to target.
It is worth noting that when the bank of England adopt inflation targeting regime, it is not only responsible for maintaining price stability but also responsible for achieving other monetary policy objectives e.g. exchange stability, higher employment levels, increase in capital accumulation, and increase in the rate of economic growth.
Effectiveness of inflation targeting
Assessment of the effectiveness of inflation targeting in UK will be done against the main macro economic indicators i.e. inflation, gross domestic product (GDP), and unemployment rate.
Inflation rate
The trend in inflation rate for the last 15 years is illustrated by the following graph
Source Office of national statistics
As illustrated by the above graph the adoption of inflation targeting since 1992 has enabled the U.K to achieve stable and low inflation rate. Since 1996 the bank of England has maintained inflation below 2.5 however from the beginning of 2004 the growth of the housing sector due to availability of credit led to increase in house price. This fed inflation in the economy and there was a steep increase in prices which reached peak in mid 2008 hitting 3.6 mark. The busting of the housing bubble in 2008 coupled with the spill over effect from the US sub prime mortgage market and downturn in the housing market forced prices to drop. The global financial crisis which started in 2008 has reduced demand for good and services all over the globe and this forced inflation to decrease from 2008 to the end of 2009. Furthermore the closure and downsizing of business that has been evident during the crisis increased unemployment and with less income the household had to cut on spending thereby reducing aggregate demand and price. To prevent the economy from sliding into recession the bank of England had to reduce interest rate by more than 50 basis point to as low as 0.5. Reduction of interest rate together with quantitative easing has helped to accelerate spending and at the same time causing increase in prices and by February 2010 inflation had climbed to 3.1.
Economic growth
The economic growth is illustrated by growth in gross domestic product (GDP). The following graph indicated the growth in GDP for the last 15 years.
LINK Excel.Chart.8 GmaterialCopy of ir10feb3 INFLATION.xls Chart4 a p
Source Office of national statistics
The monetary policy adopted by the bank of England has facilitated economic growth for the last fifteen years. Although there was a fall in GDP in year 2002, the UK economy was better compared to other large EU countries. The sound macro economic framework which emphasize on transparency, accountability and responsibility coupled with the independence of the bank in pursuit of symmetrical inflation target has enabled it to respond appropriately to cyclical fluctuation including the recent global financial crisis. As a result of slowdown in aggregate demand the bank had to cut interest rate in order to stimulate demand. This led to reduction of interest rate from as high as 5 in the beginning of 2008 to as low as 0.5 by the end of 2009. The bank has not revised the rate upward since there is no fear of inflation as demand is still low. Due to this cut in interest rate the economy has shown some sign of improvement in 2010 as illustrated by growth in GDP.
Employment
For the past 15 years unemployment rate has been decreasing but by the end of 2008 unemployment rate started to increase due to the global financial crisis which led to downsizing and closure of business.
Unemployment rate for the past fifteen years is illustrated in the following graph
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MERGEFORMATINET
As indicated by the graph above it is clear that the inflation targeting regime has enabled the country to maintain low unemployment rate. Though the rate of unemployment increased from 2008, the rate was below other developed nation such as the US. The increase in unemployment rate from 2008 was due to global financial crisis and was not a problem unique to the UK as most countries across the globe also experienced increase in unemployment rate.
As illustrated by the above macroeconomic variable it is evident that inflation targeting regime adopted by the bank of England has enabled the country to maintain stable and low inflation. In addition the growth in the economy coupled with low unemployment rate further attest to the fact that the policy has been effective in the last 15 years.