Inflation Targeting in the United Kingdom

Viertel, Benjamin

Inflation Targeting in the United Kingdom

Zusammenfassung

Inhaltsangabe:Introduction:
(A)n internal standard, so regulated as to maintain stability in an index number of prices, is a difficult scientific innovation, never yet put into practice.
Especially since the operational introduction as central bank monetary policy framework in the early 1990s in New Zealand, the United Kingdom (UK), Canada and Sweden, inflation targeting has gained both empirical and theoretical relevance as a monetary policy strategy.
In this paper I relate to inflation targeting theory and its framework in the UK. For that purpose I first regard the development of inflation targeting in respect to other monetary policy strategies in sections (2.2) and (2.3). I will answer the question what the actual target variable is and why one would want to have inflation being low and stable. Then there is some complexity because the development of inflation targeting has to be viewed in relation to paradigmatic debates between Monetarist and New-Keynesian insights. In the sections (2.4) and (2.4) I present the two fundamental views of how an inflation targeting framework should be modelled. By stating some equations from basic theoretical literature, I try to give a overview about the dfferent characteristics of that monetary policy strategy and how there is still controversy about the way of modelling. Chapter (3) is concerned with the operational framework in the UK, including statements to historical developments at the Bank of England in section (3.1). In particular, gaining of operational independence in setting interest ratessection (3.1.5)was an important step for the Bank. The present monetary policy framework will be reviewed in section (3.2), in detail relating to the Banks publication policysection (3.2.2)and the inflation forecasting processsection (3.2.3).
The Bank of Englands model of the transmission mechanism is reviewed in section (3.3). This includes the interest rate setting process, the role of money and the relationship between inflation and inflation expectations. Finally, I discuss some economic effects that changed the British economy since the introduction of inﬂation targetingsection (3.4). Inhaltsverzeichnis:Table of Contents:
1.Abstract2
2.Monetary Policy2
2.1Introduction2
2.2Monetary Policy2
2.2.1Monetary Policy Strategies in Theory2
2.2.2Monetary Stability as an Aim of Monetary Policy4
2.2.3Empirical Monetary Strategies 5
2.2.4Monetary Transmission Mechanisms6
2.3Inflation […]

Leseprobe

Inhaltsverzeichnis

Benjamin Viertel

Inflation Targeting in the United Kingdom

ISBN: 978-3-8366-2596-8

Herstellung: Diplomica® Verlag GmbH, Hamburg, 2009

Zugl. Technische Universität Chemnitz, Chemnitz, Deutschland, Diplomarbeit, 2008

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Contents

List of Figures

III

1 Abstract

2 Modelling Inflation Targeting

2.1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.2

Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.2.1

Monetary Policy Strategies in Theory . . . . . . . . . . . . . . . . .

2.2.2

Monetary Stability as an Aim of Monetary Policy . . . . . . . . . .

2.2.3

Empirical Monetary Strategies . . . . . . . . . . . . . . . . . . . . .

2.2.4

Monetary Transmission Mechanisms

. . . . . . . . . . . . . . . . .

2.3

Inflation Targeting as Monetary Policy Strategy . . . . . . . . . . . . . . .

2.3.1

Characterisation

. . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.3.2

The Origins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.3.3

On Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.3.4

Form of the Target and the Policy Horizon . . . . . . . . . . . . . .

2.3.5

Asset Price Bubbles and Rapid Expansion of Credit . . . . . . . . .

2.3.6

Critical Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.4

The Instrument Rule Model . . . . . . . . . . . . . . . . . . . . . . . . . .

2.4.1

Modelling Inflation Targeting . . . . . . . . . . . . . . . . . . . . .

2.4.2

Kydland and Prescott's Time Consistency Problem . . . . . . . . .

2.4.3

Barro and Gordon Introduce Reputation to the Game . . . . . . . .

2.4.4

McCallum and the Monetary Base

. . . . . . . . . . . . . . . . . .

2.4.5

The Taylor Rule For Interest Rate Setting . . . . . . . . . . . . . .

2.4.6

Asymmetric Preferences and Non-linear Taylor Rules . . . . . . . .

2.4.7

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.5

The Target Rule Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.5.1

Svensson's Model in the New Keynesian Framework . . . . . . . . .

2.5.2

Some Aspects in Critical Discussion . . . . . . . . . . . . . . . . . .

2.6

Summary

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 The Process of Inflation Targeting in the UK

3.1

Some Historical Issues

. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.1.1

Development of the Bank of England . . . . . . . . . . . . . . . . .

3.1.2

Previous Monetary Policy Regimes . . . . . . . . . . . . . . . . . .

3.1.3

Adoption of Inflation Targeting . . . . . . . . . . . . . . . . . . . .

3.1.4

Operational Framework from 1992 - 1997 . . . . . . . . . . . . . . .

Contents

3.1.5

Bank of England Operational Independence . . . . . . . . . . . . .

3.1.6

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.2

Present Monetary Policy Framework at the Bank of England . . . . . . . .

3.2.1

Core Purposes and Monetary Strategy . . . . . . . . . . . . . . . .

3.2.2

The Bank's Publication Policy . . . . . . . . . . . . . . . . . . . . .

3.2.3

Forecasting Inflation at the Bank of England . . . . . . . . . . . . .

3.3

Bank of England Transmission Mechanism . . . . . . . . . . . . . . . . . .

3.3.1

The Transmission Mechanism in Overview . . . . . . . . . . . . . .

3.3.2

Interest Rate Setting Process and Quantitative Effects

. . . . . . .

3.3.3

Financial Markets and Spending Behaviour . . . . . . . . . . . . . .

3.3.4

From Changes in Spending Behaviour to GDP and Inflation . . . .

3.3.5

The Role of Money . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.3.6

Relationship between Inflation and Inflation Expectations

. . . . .

3.4

Effects of Inflation Targeting in the United Kingdom . . . . . . . . . . . .

3.4.1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.4.2

Basic Economic Developments After Inflation Targeting . . . . . . .

3.4.3

Inflation Targeting and the Exchange Rate . . . . . . . . . . . . . .

3.4.4

Empirical Evidence of a Non-linear Taylor Rule . . . . . . . . . . .

3.4.5

Efficacy and Impact on Social Welfare

. . . . . . . . . . . . . . . .

3.4.6

Inflation Targeting and The Household Sector After the Financial

Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.4.7

Expected Inflation as a Metric of Heightened Credibility . . . . . .

3.5

Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 Conclusion

Bibliography

List of Figures

2.1

A Real Taylor Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.1

UK Leaving the ERM

. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.2

Bank of England Structure . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.3

Stylised Forecast Sequence . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.4

Bank of England Transmission Mechanism . . . . . . . . . . . . . . . . . .

3.5

Bank of England Official Bank Rate . . . . . . . . . . . . . . . . . . . . . .

3.6

UK Inflation Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.7

UK Gross Domestic Product . . . . . . . . . . . . . . . . . . . . . . . . . .

3.8

UK Unemployment Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.9

UK Inflation Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . .

III

1 Abstract

"[A]n internal standard, so regulated as to maintain stability in an index number of prices,

is a difficult scientific innovation, never yet put into practice."

Especially since the operational introduction as central bank monetary policy framework in

the early 1990s in New Zealand, the United Kingdom (UK), Canada and Sweden, inflation

targeting has gained both empirical and theoretical relevance as a monetary policy strategy.

In this paper I relate to inflation targeting theory and its framework in the UK. For that

purpose I first regard the development of inflation targeting in respect to other monetary

policy strategies in sections (2.2) and (2.3). I will answer the question what the actual

target variable is and why one would want to have inflation being low and stable. Then

there is some complexity because the development of inflation targeting has to be viewed in

relation to paradigmatic debates between Monetarist and New-Keynesian insights. In the

sections (2.4) and (2.4) I present the two fundamental views of how an inflation targeting

framework should be modelled. By stating some equations from basic theoretical literature,

I try to give a overview about the different characteristics of that monetary policy strategy

and how there is still controversy about the way of modelling. Chapter (3) is concerned

with the operational framework in the UK, including statements to historical developments

at the Bank of England in section (3.1). In particular, gaining of operational independence

in setting interest rates--section (3.1.5)--was an important step for the Bank. The present

monetary policy framework will be reviewed in section (3.2), in detail relating to the Bank's

publication policy--section (3.2.2)--and the inflation forecasting process--section (3.2.3).

The Bank of England's model of the transmission mechanism is reviewed in section (3.3).

This includes the interest rate setting process, the role of money and the relationship

between inflation and inflation expectations. Finally, I discuss some economic effects that

changed the British economy since the introduction of inflation targeting--section (3.4).

Keynes (1923).

2 Modelling Inflation Targeting

2.1 Introduction

In this section, I give an explanation of the development of theories relating to modern

inflation targeting models. Therefore, I give insights into the main theoretical publications.

The aim is to discuss inflation targeting theory in relation to monetary policy in general,

and different views within the inflation targeting research, for there is controversy regarding

which kind of model suits best.

I will not be able to discuss the modelling in detail, but

I find it useful to quote some of the essential equations. It is unclear what terms actually

appear in central banks' objective functions and what weights each term receives.

It is also

unclear what weights and terms should appear, since there is this professional disagreement

over proper model specifications. Later, some empirical evidence from the UK will give a

hint in section (3.4.4). First, we will have a look at monetary policy in general and the

question what the actual target variable in inflation targeting is.

2.2 Monetary Policy

2.2.1 Monetary Policy Strategies in Theory

While monetary theory is researching the effects of money supply and interest rate

variations by modelling, the theory of monetary policy analyses the monetary order

including its institutions, aims, instruments and their effects. Then, practical monetary

policy is the whole amount of done or foreseen actions to regulate and steer the money

See, for example, discussions between McCallum and Nelson (2005); McCallum and Nelson (1999) and

Svensson (2005); Svensson and Woodford (2004); Svensson (2001).

See McCallum and Nelson (2005), p. 599.

See section (2.2.4).

2 Modelling Inflation Targeting

supply, interest rates and liquidity of the economy.

With these actions, monetary policy

also influences outcomes like economic growth, exchange rates with other currencies and

unemployment. Where currency is under a monopoly of issuance, or where there is a

regulated system of issuing currency through banks which are tied to a central bank, the

monetary authority has the ability to alter the money supply and influence the interest

rate. The beginning of monetary policy as such comes from the late 19th century, where

it was used to maintain the gold standard. Since the 1970s, monetary policy has generally

been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods

system still ensured that most nations would form the two policies separately.

The primary

tool of monetary policy is open market operations. This entails managing the quantity of

money in circulation through the buying and selling of various credit instruments, foreign

currencies or commodities. All of these purchases or sales result in base currency entering

or leaving market circulation. For the UK, this will be discussed in more detail in section

(3.3.2). Usually, the short term goal of open market operations is to achieve a specific

short term interest rate target. In other instances, monetary policy might instead entail

the targeting of a specific exchange rate relative to some foreign currency or else relative

to gold.

It is useful to develop a strategy for the application of monetary policy instruments.

In monetary policy there are ultimate aims and sub-ordinate targets. Ultimate aims are

targets for stability and growth, sub-ordinate--or intermediate--goals are, for example,

annual growth rates of a certain monetary aggregate.

Monetary policy strategies can be

categorised as follows:

Discretionary monetary policy leads to monetary policy actions in the case of the occur-

rence of a certain situation. It is used to harmonise economic cycles by using an

anti-cyclical policy.

A policy regime based on discretion makes no public (or just

vague) commitments about its objectives and future actions. It reserves the right

to set monetary policy from month to month according to the assessment of current

conditions looking at 'everything'.

See Peto (2002), p. 159.

See Friedman (2004), p. 9976ff.

The other primary means of conducting monetary policy include discount window lending (i.e. lender

of last resort), fractional deposit lending (i.e. changes in the reserve requirement), moral suasion (i.e.

cajoling certain market players to achieve specified outcomes), and 'open mouth operations' (i.e. talking

monetary policy with the market). See Friedman (2004), p. 9976ff.

See Peto (2002), p. 186.

See Peto (2002), p. 190ff.

See Bernanke (1999), p. 5.

2 Modelling Inflation Targeting

Rule-based monetary policy expresses the 'built-in-stabiliser' that works automatic and

without external decisions. Rule-based policies are proposed by the Monetarists (for

example Friedman

, H.C. Simon) and by new classics--see, for example, Kydland

and Prescott (1977). Discretionary monetary policy has in the eyes of the new classic

school an inflation bias which has to be controlled by legislative rules.

Rules create credibility that the monetary authority will not abuse its powers. On the

other hand rules deprive the central bank's ability to deal with unusual circumstances.

Discretion preserves flexibility and enables to respond to new information. But on the

other hand the lack of perceived discipline may foster uncertainty in the public mind.

Being a combination of both concepts, formula flexibility means that the central bank

sets certain levels of indicators. If they are outrun the bank is allowed to react.

Besides

the analytical story of rules versus discretion, the development of both is also based on a

fundamental--paradigmatic--change in views, so that speaking of 'rules' mostly relates to

a more Monetarist view, while speaking of 'discretion' means kind of a (New-)Keynesian

perspective.

2.2.2 Monetary Stability as an Aim of Monetary Policy

While speaking of inflation targeting, we always imply that there are positive effects of

low and stable inflation. Monetary stability is viewed as basic condition for a market

economy and monetary policy is known as the best instrument for achieving that aim.

Economic costs of inflation arise because the functions of money are disabled by certain

degree--even if the inflation is correctly anticipated. These costs arise from suboptimal

keeping of money by private agents, menu costs and fixed amounts in the tax legislation.

Relating to baseline discussion, supporters of trading higher inflation rates for positive

effects on employment, growth or the states finances are not based on solid theoretical and

empirical models, as argued by Bofinger , Reischle and Schächter (1996).

In addition,

Being a former adherent of Keynes, Milton Friedman developed his fundamental criticism against

anti-cyclical stabilisation policy. In empirical research he found discretionary interventions having

destabilising effects due to lags in the transmission process. So he argued in favour of stabilisation

policy based on monetary policy. See Friedman (1948).

See Peto (2002), p. 190ff.

See Bernanke (1999), p. 5.

See Peto (2002), p. 192.

For further discussion of these issues see Bofinger , Reischle and Schächter (1996), p. 78ff.

Apparently being New Classics, they summarise analyses concerning the long-term trade-off between

unemployment and inflation, known as the Phillips-curve to the fact that effects on employment are

nothing but short-term and transient. See Bofinger , Reischle and Schächter (1996), p. 39.

2 Modelling Inflation Targeting

the positive relationship between inflation and real growth modelled by Tobin (1965) is

viewed as dissatisfactory.

The fact, that the state should finance itself by issuing money

is not true in economies with a well-adapted tax system and it is not possible with an

independent central bank.

Contrary, on empirical basis the relationship between inflation

and economic growth is viewed as being negative.

So, with inflation targeting being the

explicit effort to reach monetary stability, the inflation targeter's case rests on these

arguments:

In the long run, the inflation rate is the only macro-economic variable that monetary

policy can affect. This not because unemployment and related problems have become

less urgent concerns, but short-run fluctuations in the economy are seen less easy to

influence.

Even moderate rates of inflation are harmful to economic efficiency and growth and the

maintenance of a low and stable inflation rate is important for achieving other macro-

economic goals, for example high real growth, low unemployment, financial stability,

and a not-too-excessive trade deficit.

So, price stability as the primary long-run goal of monetary policy provides a key con-

ceptual element in the overall framework of policy-making. That framework helps policy-

makers to communicate their intentions to the public and to impose some degree of ac-

countability and discipline on the central bank and on the government itselft.

2.2.3 Empirical Monetary Strategies

Besides analytical distinctions one can find different monetary strategies on the empirical

level. The exchange-rate focussed monetary policy was practised until the crash of the

Bretton-Woods-System in 1973 from most central banks. This system forced the central

banks to interventions on the exchange market to keep the exchange rate on a fixed level.

The trend focussed policy was introduced under the influence of Monetarist theory by

the western central banks at the beginning of the 1970s. They changed to annual money

supply measures and, instead of discretionary actions, the policy was focussed on long-

See Orphanides and Solow (1990), p. 257f.

See Bofinger , Reischle and Schächter (1996), p. 76.

See Bofinger , Reischle and Schächter (1996), p. 47.

See Bernanke (1999), p. 10f.

See Bernanke (1999), p. 11.

2 Modelling Inflation Targeting

term trends of the economic capacity, known as the production potential. Although the

money supply growth rate stayed the important variable it was, however, not regulated

on a legislative basis as demanded by Friedman. Finally, the monetary policy of a direct

inflation target was introduced in the early 1990s by Great Britain and Sweden because

they had troubles using the money supply rate as an indicator. The central banks of these

countries set out maximum inflation targets or were forced to reach a certain inflation

rate by their government. The central banks reviewed all indicators that influenced the

targeted inflation rate and used all of their instruments to reach that goal.

2.2.4 Monetary Transmission Mechanisms

The way monetary policy is working through to the real economy is called the monetary

transmission mechanism. While the Keynesian--respectively interest structure based--

approach leads to a broad amount of indicators, the Monetarist view is in principle a

reduction to the monetary base as the relevant indicator and instrument for the expected

inflation. Relative to the complex Keynesian transmission model the Monetarist approach

is therefore very simple.

The same is true for the theory of the direct international price

relation where the exchange rate is the most important indicator and--again--instrument

at the same time. On the other hand, the expectations theory bases on all relevant

economic information on which one can develop an understanding of the expectations of

the market agents. This is particularly true for wages and nominal interest rates of long-

term bonds. The expectations theory bases on the interest rate structure theory and is

a key element for inflation targeting. This is because time inconsistencies between the

monetary authorities actions' and their effects lead to an inflation forecast targeting

based on agent's expectations.

Inflation expectations of the market actors can be used

as a link between the central banks instruments and the ultimate target of monetary pol-

icy.

Besides the--additional--usage of traditional intermediate indicators, in an inflation

targeting framework the central bank has to be able to adjust its operating target--the

interest rate--due to the time-lag by the usage of information about the future. Inflation

rate targeting is then practised over the intermediate target of inflation rate forecasts. This

implies the communication of these forecasts, which are regularly published in reports of

the central bank. So the actual target variable is the forecast of inflation, not the inflation

See Peto (2002), p. 193f.

See Bofinger , Reischle and Schächter (1996), p. 245.

See Bofinger , Reischle and Schächter (1996), p. 245f.

See Bofinger , Reischle and Schächter (1996), p. 369.

2 Modelling Inflation Targeting

rate.

2.3 Inflation Targeting as Monetary Policy Strategy

2.3.1 Characterisation

Having the frame laid out, we find now that inflation targeting is a rule-based concept

of monetary policy where the central bank is trying to reach the final target of monetary

stability without using traditional intermediate targets as for example exchange rates

or the money supply.

In the words of Cukierman and Muscatelli (2008), the positive

theory of monetary policy in developed economies has reached a broad consensus in recent

years that conceptualises monetary policy as follows:

"[P]olicy authorities minimise a linear combination of the quadratic deviations of inflation

and of output from their respective targets (the inflation and the output gaps in what follows),

and the main policy instrument is the short-term rate of interest."

The fundamental thought is to fight the insecurities and time-lags between action and

effects in the monetary transmission process by the monitoring of a large amount of

indicators and to direct monetary policy by the fixation of a target value for the price level

respectively the inflation rate. The reason for many countries to develop such a strategy

were no theoretical advantages, but the breakdown of traditional relationships between

the money supply growth rate or exchange rate and prices. Therefore an intermediate

target strategy was made impossible. But with direct inflation targeting is also not able to

fully control the price level by its instrument, as stated by Deutsche Bundesbank (2008).

The inflation target is formulated and communicated over a quantitative value or a target

range, which the central bank commits itself to. On the ultimate target level there are two

distinct forms of inflation targeting:

Explicit inflation targeting, where countries publish the inflation rate target. This is

popular in countries with adverse inflation development in the past because it raises

See Mishkin (2002), p. 3.

Even when the discussion about discretion in inflation targeting is lasting.

See Bofinger , Reischle and Schächter (1996), p. 365ff.

Cukierman and Muscatelli (2008), p. 1.

See Deutsche Bundesbank (2008), p. 1.

2 Modelling Inflation Targeting

transparency of the monetary policy, especially if the central bank law is not clear

in its formulation of a target and if monetary policy is not completely independent.

This transparency about the ultimate target of monetary policy is therefore especially

relevant for the system's credibility.

Implicit inflation targeting, where countries do not publish such kind of targets but express

by action their commitment to a goal of monetary stability.

Using explicit inflation targeting, the central bank is communicating its strategy as well

as its targets to explain the monetary policy actions. The commitment of the central

bank on an inflation target is mostly institutional initialised with the definition of clear

sanctions (in form of personal changes), if the inflation targets cannot be fulfilled. These

mechanisms of raised transparency and accountability in management raise the central

bank's credibility in public.

Disadvantages of this concept are due to a greater amount

of complexity, therefore less transparency for the public and the danger of disorientation

of monetary policy decisions.

The instrument in an inflation targeting framework is set

after a certain rule. While straightforward in principle, this feedback rule--as it was

firstly cited by Taylor (1993a)

--is in practice likely to be quite complex. The feedback

variable is the full probability distribution of inflation outcomes, into which will feed a lot

of information variables. This complexity confers both costs and benefits. The benefits

derive from the rule's use of a wide range of information variables, as under the optimal

feedback rule. The costs are the loss of simplicity and thus transparency about just what

monetary policy is doing and why. That cost could well be important if agents believe

that complexity is being used as a facade for periodic inflation surprises. An inflation bias

might well then obtain. In response to this, most inflation-targeting countries--the UK

among them--have made efforts to spell out their reaction functions in clear terms.

2.3.2 The Origins

Most of the elements of inflation targeting could be found in the monetary policy of Ger-

many and Switzerland in 1999. The Maastricht Treaty, the basis for the European mone-

tary union, mandates price stability as the primary objective of the new European Central

See Bofinger , Reischle and Schächter (1996), p. 365ff.

See Svensson (2001), p. 2.

See Mishkin (2002), p. 2.

See Deutsche Bundesbank (2008), p. 1.

Which is discussed in section (2.4.5).

See Haldane (1998), p. 19f.

2 Modelling Inflation Targeting

Bank. Most countries either adopted inflation targeting as a response to an unexpected

unhinging of an earlier managed exchange rate regime--as in Finland and Sweden; or as

a result of the failure of monetary targeting because of the vicissitudes of money velocity

during the 1970s and 1980s--as in Canada and New Zealand; or, in the UK case, as a

result of both.

The intellectual roots of inflation targets can be traced back to the last

century--to Marshall (1887) and Wicksell (1898). Later, Fisher (1911) and Keynes (1923)

both put forward monetary policy schemes which target explicitly an index number for

prices. Sweden did an experiment with an explicit price-level standard during the early

part of the 1930s.

2.3.3 On Transparency

As previously pointed out, a key element of inflation targeting is transparency.

It is

achieved by the communication of goals, targets, strategies and forecasts on a regular

basis and the members of the central bank speaking to the public. Reasons for inflation

goals can be laid out, the tasks and borders of monetary policy can be explained.

the eyes of Mishkin (2004), transparency is firstly effecting credibility of the monetary

policy. Is the credibility raising, then inflation targets are easier to realise because inflation

expectations are similarly kept to a low level. A high level of transparency can solve the

problem of time inconsistency because the control of the monetary policy and its actions is

easier. Systematic failures are easier to monitor, their execution by the central bank is less

probable. Although central banks raised their transparency by the introduction of inflation

targeting enormously, there could be even more. In most cases there are no publications

to the form of the target function and the weight factors for the output stabilisation.

Inflation or monetary policy reports are published by Canada, New Zealand, Sweden and

Spain, as well as in the UK. They allow inflation targeting central banks to expose to

the wider world the analysis underlying their monetary policy advice. A second are the

minutes of the monthly meeting at which monetary policy decisions are made. Third

example of greater transparency is the publication of forecasts for inflation (and for other

variables). These serve as a summary statistic of the information variables upon which

policy is set, thus simplifying monitoring by outside agents.

See Haldane (1998), p. 2.

See Haldane (1998), p. 2f.

See Mishkin (2004), p. 49.

See Mishkin (2004), p. 53.

See Haldane (1998), p. 20.

2 Modelling Inflation Targeting

2.3.4 Form of the Target and the Policy Horizon

Besides the question which variable should be targeted in monetary policy in general--

money supply, exchange rate or inflation--one can question the design of the target. Some

central banks give a clear numeric value while others just formulate a target range. The

huge advantage of a range is its flexibility. The control of the inflation is never completely

possible so the target range secures from deviations that occur often in the case of a certain

target point. But the publication of a target range also has disadvantages. It can raise

insecurities over the inflation in comparison to a precise target value. A narrow target range

on the other hand can reduce inflation expectations but brings greater danger of missing

the aim. A broad target range can foster insecurities of monetary policy aims and therefore

reduce accountability.

The time horizon within to reach the inflation target also leads

to discussions. The delayed effects of monetary policy actions on inflation--two years in

recent years--can lead to problems. Is the inflation target given too less time, the inflation

cannot be controlled properly. Misses of the inflation target are sincere, even if the central

bank's decisions where right. A too short time horizon can also lead to unnecessary high

amounts in the usage of instruments to reach the inflation target.

Furthermore variations

of the output would increase if the inflation was targeted backwards too fast to its target

value with a short horizon.

A horizon of two years seems to be optimal, as stated by

Mishkin and Schmidt-Hebbel (2001). It gives the monetary policy the time their actions

need to influence the inflation and it reduces output variability to a low level.

2.3.5 Asset Price Bubbles and Rapid Expansion of Credit

The appropriate response of monetary policy to asset price bubbles and any associated

rapid expansion of credit is a matter of debate amongst central bankers and monetary

economists. In the aftermath of the collapse of the dot-com bubble and the more recent

wider correction to international share values, a number of commentators have argued that

the achievement of price stability by central banks may be associated with heightened risks

of financial instability, too. They argue that central banks should not focus solely on

inflation prospects, but also take account of developments in asset prices, debt and other

indicators. They may be symptomatic of incipient financial imbalances which is neatly

See Mishkin (2001), p. 212.

See Mishkin and Schmidt-Hebbel (2001), p. 184.

See Meyer (2001), p. 7.

See Mishkin and Schmidt-Hebbel (2001), p. 184.

2 Modelling Inflation Targeting

summarised by Crockett (2003):

"(I)n a monetary regime in which the central bank's operational objective is expressed

exclusively in terms of short-term inflation, there may be insufficient protection against the

build up of financial imbalances that lies at the root of much of the financial instability

we observe. This could be so if the focus on short-term inflation control meant that the

authorities did not tighten monetary policy sufficiently pre-emptively to lean against excessive

credit expansion and asset price increases. In jargon, if the monetary policy reaction function

does not incorporate financial imbalances, the monetary anchor may fail to deliver financial

stability."

According to this view, policy should be tightened if the policy-maker believes that an

asset price bubble is developing, or if balance sheets show signs of becoming stretched

through excessive debt accumulation, even though inflation may be well under control.

Failing to do this may raise the likelihood of financial instability. Central bankers should

be especially concerned about the broader set of symptoms that usually accompany asset

price booms, namely a built-up of debt and a high rate of capital accumulation. During

the asset price boom, which may initially be prompted by an improvement in economic

fundamentals, such as an increase in total factor productivity growth occasioned by a new

technology, balance sheets may look healthy as the appreciation in asset values offsets the

build-up of debt. But when optimism turns to pessimism, the correction in asset values

results in a sharp deterioration in net worth, stretched balance sheets, retrenchment and

possible financial instability.

This process may be further aggravated if banks respond to

the deterioration in balance sheets by restricting lending, i.e. a credit crunch.

But on the

other hand raising interest rates to prick an apparent bubble may simply produce the sort

of economic collapse one wants to avoid. So in the eyes of Bean (2003)--a member of the

Bank of England--the best that one can do is deal with the consequences as the bubble

bursts or financial imbalances unwind. This debate revolves around the desirability and

feasibility of pre-emptive monetary policy tightening in order to prevent subsequent

financial instability. Much of the growing literature examining this question focuses on

stochastic asset price bubbles and analyses the implications in a suitably calibrated macro-

economic model of following either a simple Taylor rule or an inflation-forecast-targeting

rule augmented with the asset price. The bottom line of this literature seems to be that

the results hinge on the particular stochastic assumptions regarding the asset price (as

well as other shocks that might provide a fundamental explanation for the asset price

Italics in original, Crockett (2003), p. 1.

See Bean (2003), p. 20.

Governments all over the world are right now working against a threatening credit crunch.

2 Modelling Inflation Targeting

movements) and above all on the information available to the policy maker.

Bean (2003)

and Cecchetti , Genberg and Wadhwani (2002) do not see any difficulty in principle in

taking on board the implications of concerns about asset price bubbles, incipient financial

imbalances, etc., within an inflation targeting framework.

2.3.6 Critical Discussion

From an analytical perspective, the differences between inflation targeting and monetary

targeting are just semantic. Both regimes shoot for the same end-point: a specified growth

path for nominal magnitudes. Given the transmission lags in monetary policy, both rely

on a forward-looking inflationary assessment when monetary policy is being set. Haldane

(1998) states, that the difference between them hinges on the weights each attaches to dif-

ferent information variables when forming the forward-looking inflation assessment.

therefore relates to differences in the foundational paradigm. Contrary to monetary tar-

geting, inflation targeting should be more responsible for real economic values. In theory,

pure monetary targeting is a limiting case of inflation targeting.

The weight attached

to monetary variables is unity, and the weight attached to non-monetary variables is zero.

Inflation targeting means using an eclectic mix of information variables, with non-zero

weights assigned to both real and monetary magnitudes when forming an inflationary as-

sessment.

In practice, this distinction and these restrictions are largely hypothetical.

Studies of the Bundesbank's reaction function (such as Clarida and Gertler (1995); Mus-

catelli and Tirelli (1996); Neumann (1995)) confirm that real as well as monetary variables

help to explain its actions over recent years. Actual and expected inflation and output

gaps are often found to play a prominent explanatory role with money having a bit part.

As stated above, the time-lag of monetary policy instruments on the inflation and shock

effects inside this time-lags lead to an inflation forecast targeting. Published inflation fore-

casts are used as intermediate targets. Bofinger , Reischle and Schächter (1996) criticised

this by pointing to the fact that the inflation rate forecast does not show all characteristics

of an intermediate target. It is not well controllable by monetary instruments and it is not

showing a stable relationship with the final target, the inflation rate, as it is with exchange

See Bean (2003), p. 21.

See Bean (2003), p. 22.

See Haldane (1998), p. 3.

There is an oppositional meaning to that subject, quoting "... other goals are submitted under the goal

of the inflation rate target. Secondary goals--for example stabilisation of the output--are possible in

principle and wished but there is not necessarily a numeric value for it." Svensson (2001), p. 2.

See Haldane (1998), p. 3.

2 Modelling Inflation Targeting

rates and money supply.

Related to the UK, these aspects are further discussed in section

(3.3.6). Another criticised aspect is the low inflation rate for the price of output variability.

The short-term goal conflict between inflation and output in case of supply shocks makes

monetary policy decide between one of these two goals.

Furthermore there is said that

inflation targeting, although it is related to monetary policy rules, provides a too huge

space for discretionary decisions. This argument is closely related to the definition of

monetary policy rules. Inflation targeting can be viewed as optimising action to achieve

fixed targets. It is forming a framework for the central bank to offer sufficient flexibility for

optimal decisions, as stated by Bernanke (1999).

On empirical basis, all central banks

who did explicit inflation targeting reached self-made goals. But the 1990s were a phase

with low inflation rate and there were a lot of other countries who reached an inflation

rate goal of one to four percentage points.

Last, but not least, a problem could arise

from the false impression a central bank establishes: to be able to defeat inflationary

tendencies from their beginnings, while this is quiet impossible with the complex structure

of the interest rate structure transmission mechanism and the very indirect influence of

higher inflation rate expectations on the actual inflation rate. Due to the difficulties of this

fine-tuning of monetary policies it would--in the eyes of Bofinger , Reischle and Schächter

(1996)--be more appropriate to work with an implicit inflation targeting. To sum it up,

in using inflation targeting, there is a trade-off between the transparency relating to the

final target and the loss of reputation by missing the short-term inflation target due to

exogeneous shocks.

2.4 The Instrument Rule Model

2.4.1 Modelling Inflation Targeting

In the previous sections the discussed inflation targeting characteristics were relatively

general. Key element of economic research is the formulation of inflation targeting models

relating different economic indicators and instruments, as, for example, inflation rate, in-

terest rate and the production growth rate in mathematical models. Therefore, in the last

40 years different economic models were developed and empirically tested via mechanisms

See Mishkin (2002), p. 4.

See Bernanke (1999), p. 299.

See Bernanke (1999), p. 6.

See Bofinger , Reischle and Schächter (1996), p. 373.

See Bofinger , Reischle and Schächter (1996), p. 375f.

Details

Seiten
Erscheinungsform: Originalausgabe
Jahr: 2008
ISBN (eBook): 9783836625968
DOI: 10.3239/9783836625968
Dateigröße: 1.1 MB
Sprache: Englisch
Institution / Hochschule: Technische Universität Chemnitz – Fakultät für Wirtschaftswissenschaften
Erscheinungsdatum: 2009 (Februar)
Note: 1,3
Schlagworte: bank england asset price bubbles monetary stability inflationssteuerung großbritannien

Autor

Benjamin Viertel (Autor:in)

Inflation Targeting in the United Kingdom

Zusammenfassung

Leseprobe

Inhaltsverzeichnis

Details

Autor

Benjamin Viertel (Autor:in)