Monetary Policy in Practice:
What the journals do not say
Specialist Adviser to the House of Lords
Economic Affairs Committee
University of York
Monetary policy is conducted
• using inflation targetting
• by an independent central bank
Who should determine the remit?
Bank of England Act 1998
“In relation to monetary policy, the objectives
of the Bank of England shall be:
(a) to maintain price stability, and
(b) subject to that, to support the economic
policy of Her Majesty’s Government,
including its objectives for growth and
• Central target of 2.5% defined in terms of RPIX
(consumer prices less mortgage interest payments)
• To maintain inflation within 1% either side of
• Failing this, the Governor must write an open
letter to the Chancellor to explain why inflation is
outside the band and how this will be rectified
The Monetary Policy Committee
• The Bank had to constitute the MPC to make the
interest rate decision
• Five members of the MPC are ex-officio as
employees of the Bank
- Deputy Governor
- 2 Executive Directors
- Chief Economist
• Four external members appointed by the
Issues about the MPC
• Who is really responsible: MPC or Chancellor?
• How should external members be chosen?
• Does conflict of interest affect the choice?
• Accountability- credibility – transparency
• Effectiveness of
- Quarterly Inflation Report
- Monthly Minutes
• Voting arrangements
• Communications between
- the Governor and Chancellor
- MPC and Government
• What is the role of the Court of the Bank of
Strict or flexible inflation targetting?
What does “subject to that” mean?
Should the following be taken into account
- Exchange rate
- Asset prices
- House prices?
• Should RPI, RPIX or HICP be the measure?
• What value should the central inflation
• What sort of band is appropriate?
- Should the band be symmetric?
• Should the Bank aim to be above as often as
• Over what horizon should the Bank target
• Should inflation always be kept within the band no
matter the consequences for interest rates?
• What shocks should be offset and what
- demand v. supply shocks
- domestic v. foreign shocks
- real v. nominal shocks
- temporary v. permanent shocks
• Response lags imply forward-looking objectives
• Forecasts or projections?
- constant interest rates over forecast period
- should MPC give a Fed-type “bias”
• Need for an inflation forecasting model
- one model for all (eg Bank’s)
- each MPC member makes own forecasts
- independent forecasts
• How to forecast the exchange rate?
1. Market rates
2. Asset prices
4. Exchange rate
BOE model: in the first year the exchange rate
accounts for 80%
The interest rate decision
Why do MPC members differ in their views?
- different forecasts?
- different view of transmission
- how much should be revealed in the
Rules v. Discretion
• Which should the Bank use?
• Theory says a backward-looking rule is best
as it reduces the variances of both inflation
• But who said…….
“I do not think there is any rule which anyone has
proposed which would be a feasible rule, in the sense
that anyone would credibly believe that the MPC
would literally work month in, month out, without
deviating from it”
“…whatever rule one could think of today as being the
best rule, would be superseded by a better rule six
months down the road”
“If your rules keep changing all the time it is not a rule
and it looks like discretion.”
Some more quotations
“What a Taylor rule does is essentially to say that if
inflation is, or looks like it is going to be, above the
target, and if growth is accelerating above the trend,
that is the time you should be raising interest rates.
If inflation is below target, or looks as if it is going to
move further below target, and output is below trend,
that is a time when you might be reducing interest
Now that is more like commonsense than a rule.
From that point of view…the most successful central
banks appear to have been following a Taylor rule,
even if they had never heard of such a rule in the first
Source of quotations
Evidence to the House of Lords Select
Committee on the Monetary Policy Committee
of the Bank of England
23 February 1999
• For nearly three years
- Inflation was below forecast and central target
- Output above forecast
- would a correct inflation forecast have led to a
lower interest rate?
- would a higher output forecast have led to a
higher interest rate and hence a larger inflation
• What can explain the error?
- positive supply shocks (eg productivity shocks)?
UK Inflation 1990-2003
Inflation targetting begins
1990 1992 1994 1996 1998 2000 2002
The Record cont.
• Goods and services inflation diverged
- goods inflation rose
- services inflation fell
• House price inflation was very high
• Large structural imbalances
- regional inflation differences
- industry output differences
• Can anything be done about this?
- first, consider EMU
Should the UK join EMU?
• Giving up a successful policy?
• Convergence is not the only issue
• The EMU system is non-sustainable in its
- one-size fits all interest rate policy
- Stability and Growth Pact