Inflation targeting in practice: the UK experience Speech given by John Vickers, Executive Director and Chief Economist at the Bank of England At the conference on Implementation of Price Stability, Frankfurt November 1998 1 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx Inflation targeting in practice: the UK experience In this speech,(1) John Vickers, Executive Director and Chief Economist at the Bank of England, discusses theoretical and practical issues relating to inflation targeting as used in the United Kingdom during the past six years. After outlining the role of the Bank’s Monetary Policy Committee, he considers the Committee’s task from a theoretical perspective, before discussing the concept and measurement of domestically generated inflation. Introduction we make decisions, how we seek to explain them, and how we are held accountable for doing the job we have been Six years ago this week, sterling left the exchange rate given. mechanism (ERM) of the European Monetary System, and dropped by 7% from DM 2.80 to DM 2.60. But since Next, though my task is to discuss inflation targeting from falling below DM 2.20 in l995, sterling has risen to levels the practical perspective of UK experience, I shall take a higher than before its exit from the ERM. In an economy as detour and discuss a sort of converse question: how might open to international trade as the United Kingdom, one UK practice appear from the perspective of the theory of might have expected that such large swings in the price of inflation targeting? Then finally, and returning to the theme foreign exchange would destabilise domestic price inflation. of inflation targeting in an open economy, I shall discuss the Not so. For every month since the start of 1993, inflation(2) practical and topical problem of inflation control in the face 1 has remained in a range of 2%–3 /2%. This is an of large exchange rate movements, and how the concept of uncharacteristic degree of UK price stability by recent domestically generated inflation may help in addressing it.(5) historical standards (see Chart 1). Over the same period, annual GDP growth has averaged about 3%, well above The United Kingdom’s new monetary trend, and the unemployment rate has fallen from 10% to 6.2%.(3) framework Almost immediately after coming into office, the new Chart 1 Government announced on 6 May 1997 that the Bank of RPIX inflation England would henceforth have operational independence Percentage change on a year earlier for the conduct of monetary policy. While the objectives of 30 policy remain a matter for the Government to determine, responsibility for interest rate decisions moved to the Bank’s 25 new MPC. The MPC operated for a year on a de facto basis, and now has a statutory basis under the Bank of 20 England Act. The Act also reformed the governance and finances of the Bank, and transferred responsibility for 15 banking supervision to the new Financial Services Authority; the job of government debt management has 10 moved to the Treasury. 5 The MPC has nine members—the Governor, the two Deputy Governors (David Clementi and Mervyn King), the Bank’s 0 1975 80 85 90 95 98 Executive Directors for Monetary Operations (Ian Plenderleith) and Monetary Analysis (me), and four For these six years, the United Kingdom’s nominal anchor members appointed by the Chancellor of the Exchequer: has been an explicit inflation target, and on 1 June this year, Sir Alan Budd (formerly Chief Economic Adviser at the a new statutory framework for the implementation of price Treasury), Willem Buiter (Cambridge University), stability (and much else) came into force in the shape of the Charles Goodhart (London School of Economics), and Bank of England Act 1998.(4) First, I shall briefly describe DeAnne Julius (formerly Chief Economist at British this framework, and how the operationally independent Airways). Our monthly policy meetings span two days, and Monetary Policy Committee (MPC) works within it—how decisions are taken by a vote, with the Governor having a (1) Given at the Conference on Implementation of Price Stability held in Frankfurt on 11–12 September 1998. (2) As measured by the retail price index excluding mortgage interest payments (RPIX). (3) On the Labour Force Survey measure. (4) The Act is described in more detail in the May 1998 Quarterly Bulletin, pages 93–99. (5) I am very grateful to Bank of England colleagues Bill Allen, David Barker, Willem Buiter, Spencer Dale, Andrew Haldane, Graham Kentfield, Mervyn King, Ben Martin, Paul Mizen, Jo Paisley and Chris Salmon for their helpful comments and suggestions on an earlier version. The views expressed are entirely my own, and are not necessarily those of other MPC members, or of the Bank more generally. 368 Inflation targeting in practice: the UK experience casting vote in the event of a tie. A representative from the Chart 2 Treasury attends. Inflation projection Percentage increase in prices on a year earlier The paramount statutory duty of the MPC is the 6 maintenance of price stability. This is defined in terms of a target for the annual rate of retail price inflation excluding 5 mortgage interest payments (RPIX). The Chancellor’s letter of 3 June 1998 defining the MPC’s remit says that ‘the 4 1 inflation target is 2 /2% at all times’. The remit recognises that exogenous shocks and disturbances may cause inflation 3 on occasions to deviate from the target, and that ‘attempts 2.5 to keep inflation at the inflation target in these 2 circumstances may cause undesirable volatility in output’. If the target is missed by more than 1 percentage point on 1 either side, the Governor, as chairman of the MPC, must write an open letter to the Chancellor explaining why the 0 target was missed and what action is being taken to rectify 94/2199494/394/4 95/295/3 9595/4 96/296/3 9696/4 97/297/3 9797/4 98/298/3 9898/4 99/299/3 9999/4 00/2200000/3 the situation. Subject to the paramount statutory duty of price stability, the MPC must support the Government’s Chart 3 economic policy, including its objectives for growth and GDP projection Percentage increase in output on a year earlier employment. 6 There are two main vehicles of transparency: the minutes 5 of the monthly MPC meetings and the quarterly Inflation Report, the twenty third of which was published last month. 4 The minutes give a frank but non-attributable account of 3 the Committee’s discussion, and individual votes are recorded. 2 The Report, which is prepared by Bank staff under the 1 guidance of, and with the approval of, the MPC, offers a + detailed account of recent economic developments, and _ 0 gives projections for inflation and GDP growth up to a 1 two-year horizon. 1994 95 96 97 98 99 2000 Source for Charts 2 and 3: August 1998 Inflation Report. Charts 2 and 3 show the ‘fan chart’ projections from the August Report, assuming constant interest rates. The fan UK inflation targeting from a theoretical charts are explicit about the Committee’s (best estimate of its) uncertainty about the future. The shading is rather as on perspective a contour map: at each point in time, the darkest region How might an academic surveying the United Kingdom’s contains the central projection or highest probability path new monetary arrangements from the supposedly ivory (ie the mode) and covers 10% of the probability, while towers describe the MPC in theoretical terms? I imagine paths considered decreasingly likely are in the that this academic would seek to define our objective in correspondingly lighter regions that fan out. The terms of a loss function,(1) and our behaviour in terms of an uncertainties around the central projection are not associated reaction function that relates policy decisions to necessarily symmetric—eg there is some upward skew in economic data.(2) the inflation fan chart—and so the mode, median and mean may well differ. More on this later. The loss function The minutes and the Reports are also important for It should go without saying that the MPC’s objectives are accountability to the public generally, and specifically to the given by the Act and by the remit set by the Chancellor. Bank’s Court of Directors, to the Government, and to the There is a large literature on inflation bias,(3) but it is simply Treasury Committee of the House of Commons. MPC not applicable to the MPC. We have no desire to spring members regularly give evidence before the Treasury inflation surprises to try to bump output above its natural Committee, and in June this year there were (non-statutory) rate (wherever that may be). Quite apart from the obligation confirmation hearings. I am pleased to report that we all to fulfil our statutory duty, we have the strongest passed. professional and reputational incentives, which in my (1) Summed over time and appropriately discounted. (2) This hypothetical academic might also delve into the theory of voting, but let me not get into that. (3) Stemming from Kydland and Prescott (1977), and Barro and Gordon (1983). 369 Bank of England Quarterly Bulletin: November 1998 opinion are incapable of being enhanced by financial The theoretical literature mostly, and not unreasonably, incentives, to get as close as we can to the inflation target. assumes case (b). As is well known from the work of Svensson (1997) and others, with inflation as the only The academic knows this, but has two questions.