Some Reflections on the Bank of England's Monetary Policy Committee: Inflation has Stayed Low and Growth has Stayed High

Business Economics, Oct, 2001 by Sushil B. Wadhwani

The new monetary policy framework in the UK has made an encouraging start, as inflation expectations have fallen to around target. This does not appear to have come at the cost of growth, as the unemployment rate has continued to fall, and output growth has been slightly above its average rate. A critical feature of our framework is that it specifies a symmetric target. If we persistently undershoot the target, it could eventually damage our credibility. Therefore, it will remain important to respond to the possible changes in the structural relationships that underlie our forecasting processes. While UK monetary policy is more transparent than in many other countries, our interest rate decisions appear to have surprised the markets more than those of other central banks. However, these empirical results may be distorted, because, in the early years of the Monetary Policy Committee, the markets were trying to learn how we would react to developments in the economy. Over a more recent period, the average marke t surprise associated with our decisions is broadly in line with other ma]or central banks.

It is a great privilege for me to have the opportunity to present and discuss the process of monetary policy formulation in the UK.

The New UK Monetary Framework

I shall start by briefly outlining the monetary policy framework in the UK. We have just passed the fourth anniversary of the announcement that the Bank of England would be independently responsible for the operation of monetary policy. Decisions concerning interest rates are now taken each month by a nine-member Monetary Policy Committee (MPC). Our responsibility, as defined in The Bank of England Act (which came into effect in 1998), is "to maintain price stability, and subject to that, to support the economic policy of Her Majesty's Government including its objectives for growth and employment". (1) The Chancellor gives an annual remit to the Bank, currently specified as a symmetric target for the annual growth rate of retail prices excluding mortgage interest payments (the RPIX index) of 2.5 percent, so there is a clear objective for monetary policy.

The new monetary policy framework is intended to be transparent, so we publish a quarterly Inflation Report, which contains the MPC'S inflation forecast. The minutes of our monthly policy meetings are also published, now just two weeks after the decision (though the legal requirement is six weeks), and these show the individual votes. We are individually accountable to Parliament through appearances before the relevant Select Committees.

How Has the New Framework Performed?

The new system appears to have made an encouraging start. (2) Inflation averaged around 7 percent during the 1980s and around 4.25 percent over the 1990-1997 period. But, between May 1997 and March 2001, annual RPIX inflation has averaged 2.4 percent, slightly below target. Since the introduction of the new framework, inflation has also been remarkably stable, lying within a rather narrow range (actually just 1.8-3.2 percent) during this period (Figure 1).

Note that the arrangements that existed prior to May 1997 appear to have lacked credibility in the markets. For example, in June 1995, an inflation target of 2.5 percent or less was announced and yet inflation expectations ten years ahead (derived from financial markets) generally remained above 4 percent. But market measures of inflation expectations fell sharply on 6 May 1997 following the announcement of the new monetary framework, and there have since been further falls to a level slightly lower than the target (Figure 2). This suggests that the markets believe that the current framework will deliver the target in the long-run.

Credibility may also be considered with reference to the inflation expectations of independent economic forecasters. There have been substantial falls in the consensus one-year ahead RPIX inflation forecast (3) since the new monetary arrangements were put into place. Since then, these expectations have remained very close to target (Figure 3).

It is interesting to note that UK expectations have fallen by more than US expectations, whether measured in terms of 10-year ahead market expectations or survey based measures (Figures 4 and 5). This suggests that the fall in inflation expectations may be a reflection, at least in part, of the change in the policy framework in the UK. But other factors, such as disinflationary pressures in the global economy or supply-side developments may also have helped to keep inflation low.

At the time of the creation of the MPC, there were those who thought that we would act as "inflation nutters" and that low inflation would be achieved at the cost of high unemployment. However, unemployment (4) has continued falling, from 7.2 percent in May 1997, to around 5.1 percent now (Figure 6). Output growth has averaged 2.8 percent under the new monetary framework, which compares favourably with the forty-year historical average of 2.5 percent.