How Inflation Targeting Operates in the Uk and Critically Evaluate the Benefits of Inflation Targeting

Topics: Inflation, Monetary policy, Central bank Pages: 5 (1646 words) Published: April 15, 2013
“Inflation targeting is a monetary policy strategy used by central banks for maintaining prices at a level or within a specific range.”Financial Times (n.d.). The Central Bank meets the preset targets for the annual inflation rates by changing interest rates. Inflation and interest rates are closely related. The Central Bank, therefore, uses interest rates by lowering or raising them to the set target. For example, the bank will raise interest rates if inflation looks like it is above the target or lowers interest rates if inflation is lower than the target.

In May 1997, UK’s new Government announced that the Bank of England in the country would be operated independently. A Monetary Policy Committee was set up under the Bank of England Act, which is responsible for interest rates decisions even though the Government determines the policy objectives. There are 9 members in the MPC, including the Governor of the bank, 2 Deputy Governors, 2 Bank Executive Directors and 4 external members assigned by the Exchequer’s Chancellor. The principal statutory duty of the Committee is to stabilise prices. This is defined with reference to the target for annual retail price inflation excluding payments for mortgage interest rates (RPIX). A letter by the Chancellor at the year of 1998, defining MPC’s submission states that the inflation target is maintained at 2.5 % at all times. A target may be missed by more than 1% on either side, in which event, the Governor as chairman of MPC writes a letter to the Chancellor explaining why they did not reach the target and the remedy action that is to be taken. Until 2004, the inflation target switched to 2%, which based on the Consumer Price Index (CPI) from the previous RPIX target of 2.5%. In addition to MPC’s responsibility of price stability, it must also support the Government’s objectives for growth and employment together with the Government’s economic policy.

MPC conducts its affairs in a transparent manner. There are two major engines of transparency: the quarterly inflation report prepared by the Bank staff under the direction and approval of the MPC. It gives a detailed explanation of current economic developments and a plan for inflation and GDP growth for the next 2 years. Minutes taken during the MPC's monthly meetings are also important as they give a truthful account of the discussions taken by the Committee.

The principal objective of monetary policy is to keep inflation rates low and stable over a long period of time. The MPC sets the interest rate so that the Bank of England can lend short term money to financial institutions. This is called an official repo rate which affects the entire short and long term interest rates set by financial institutions and commercial banks’ borrowers and savers. Other than that, it also affects share prices, bonds and exchange rate. Apart from adjusting the interest rate by MPC, an inflation target can also be achieved by using a policy which known as “Quantitative Easing”. From the year of 2009 to 2012, MPC purchased a total value of £375billion of UK government debt. The objective of this action was to bring more money into the economy, and then inflation would increase. This policy can be used when the inflation rate is below 2% for a short term only.

Decisions made by the Bank of England's MPC change the lives of the citizens in the UK, such as investors’ investment returns, mortgage costs for home owners, availability of jobs and inflation. These and more are directly influenced by the Committee’s monthly decisions about the right interest rate for UK. The public in UK are aware of MPC existence even though not many of them know how it carries out its work. They also believe through an opinion poll, that the country is possible to continue maintaining a low and stable inflation rate. As a result, the committees’ job will be easier if the public trust their decision.

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