Inflation Targeting

Question 1

What is the UK’s current monetary framework?

Answer 1

• Since October 1992, the UK has followed a policy of direct inflation targeting
• The aim is for inflation to between 1&4% (used to be below 2.5%)
• Interest rate adjustment was the main policy instrument
• Large view on TRANSPARENCY and CREDITIBILITY
• Money measures [M0 and M4 and Exr] gave inflation forecasts

Question 2

What happened in May 1997 to the Bank of England? Why was this significant?

Answer 2

• Bank of England was granted operational independance
• Could set r independantly of the Government
• Led to the creation of the MPC, voting on r
• 1998, BoE became statute

Question 3

What does ‘operational independance’ mean in reality?

Answer 3

• Previously, if the Government needed money, it would borrow from the Bank
• The Money Supply quantity was linked to gold
• This was until bank deposits overtook the link between gold and the currency
• Now, the Governmente must engage in monetary expansion to finance the deficit
• Independance of C.B. removes links to Government

Question 4

What is the MPC’s structure?

Answer 4

• 9 members
• Led by the Governor (Andrew Bailey)
• NO POLITICIANS
• Vote to set the interest rate every 6 weeks to the level that targets inflation the best
• “Minutes” of the MPC are published and it must be explained- increasing transparency

Question 5

What happens if the inflation target is missed?

Answer 5

• If the target is missed by +/- 1%, the Governor must write an open letter to the Chancellor explaining why it was off-target
• Set out a time scale and what they are going to do to achieve this

Question 6

What is the issue with inflation forecasting?

Answer 6

• Fan charts highlights the uncertain nature of inflation targeting

Question 7

Explain the transmission mechanism

Answer 7

• Takes ~2 years due to time lags, hence forecasts have to be looked into
• MPC uses models to produce projections
• These models provide framework to organise thinking on how economies work and how developments might affect future inflation

Question 8

Why is inflation targeting used?

Answer 8

• Allows for more stable inflation rate
• Data backs this up (fan chart less sporadic)
• The question becomes how much was inflation-targeting

Question 9

What else could have reduced the inflation? What did the Bank of England say about the time?

Answer 9

• Cheaper imports and inreased competition
• Increased LS
• No real shocks to the economy
• “The environment is unlikely to be so benign in the future”, acknowledgement of relative ease

Question 10

Was the Bank Lucky or Competant?

Answer 10

• Inflation and interest rates were low in the UK, but this was a trend among OECD nations
• Was the MPC lucky or was inflation targetinf shown as a success for the MPC?
• Credibility and transparency helped anchor expectations and gave stability
• Did they do enough concerning the asset price bubbles in 2007/08

Question 11

What is the relationship between nominal interest rates and expected inflation?

Answer 11

• r = i - πe
• Approximated by the bank rate, based on headline information
• Since 1980, i >πe
• From 2008-2023; i<πe

Question 12

Provide an overview of monetary policy from 1993 until 2007

Answer 12

• BoE operates independantly, if π increases, so does i
• Great moderation of π and Y in the 1990s onwards
• Taylor rule: IR responds to π and Y

Question 13

Provide an overview of monetary policy from 2009 until 2019

Answer 13

• ZIRP (polict at about 0%-0.5%)
• Negative real rate {~-0.8}
• QE: BoE buys government bonds, aim to lower the IR- bought ALOT (converse to the Fed)
• By changing the policy rate/buying long term bonds, you shift the curve upwards/flatten the curve

Question 14

Explain what QE is. What happened as a result of QE?

Answer 14

• When BoE purchases Government bonds, this creates a bank deposit at the C.B AS WELL AS a reserve at the private bank
• Hence a change in QE also changes in M4
• QE did not lead to an explosion in M4, because banks weren’t lending
• QE is proven to work, as 20yr bond yields fell by about 1% across 25 years

Question 15

What happened to monetary policy during the pandemic? What was the respone by BoE?

Answer 15

• Cut in IR
• Massive QE
• Expensive furloughs and tax breaks
• Debt:GDP rose to around 120%
• Inflation came back post-pandemic due to supply chains, energy shortages, less fertilizer supply, lower workforce and consumer spending
• BoE was slow at first [first MPC rise in December 2021]
• Used to the ZIRP
• Delayed raising rates, as inflation was ‘transitory’
• In December 2023, r became +ve

Question 16

What level does i have to be to have a positive r? Where is r*?

Answer 16

• i = 3-4% to have a +ve r
• Markets say i=4, NIESR say 3.25%
• Different views on r* {1-2%}
• This begs the question whether the ZIRP is gone with 4.75% IR

Question 17

What is QT? What was now realised about QE?

Answer 17

• Feb 2022: stopped reinvesting bonds of maturity
• Nov 2022: began selling guilts ~£800m
• QE stock down from £875bn to £757bn
• No real exit plan to QE
• Effect of LRIR rises, yield curve steepening
• Changing interest rates saw losses of around £130bn

Question 18

What are current events that make the future uncertain?

Answer 18

• Elections
• Geopolitical issues- Israel/Palestine, US/China, Ukraine/Russia