The New Monetary Policy Framework In The UK

Within days of Labour''s 1997 election victory, the new Chancellor of the Exchequer, Gordon Brown, radically changed the framework for the development and implementation of monetary policy, effectively making the Bank of England independent. The Policy Forum in the November issue of the Economic Journal features three articles that reflect on the rationale for and operations of the new arrangements as well as their potential implications for the European Central Bank (ECB).

In the first article, Sir Alan Budd sets out the infrastructure and operating arrangements of the new regime. At its heart is the Monetary Policy Committee (MPC) of which Budd is one of nine members. The MPC is responsible for formulating a monetary policy that meets the goal of maintaining price stability against the backcloth of the government''s objectives for growth and employment.

Budd describes in great detail the monthly cycle of the MPC and the reliance it places on formal economic modelling as well as ''judgement''. The MPC is set an operational target for the underlying inflation rate. In the event that inflation deviates from that target by plus or minus 1%, the MPC has to explain to the Chancellor in an open letter the reasons why the target has been missed, what changes will be implemented to correct it and the timeframe for action. The MPC meets monthly to make decisions on interest rates, its minutes are subsequently published and it is required to publish a quarterly Inflation Report.

In the second article, Professor Charlie Bean focuses on the vitally important question of whether the characteristics of the new arrangements are credible – specifically, is there likely to be what economists call a ''time inconsistency'' problem? Drawing on the extensive literature on the issue, Bean argues that the key issue is whether the arrangements will insulate the Bank and the MPC from short-term political pressures. As he points out, the ''contract'' between the Bank and the Chancellor is incomplete: a numerical target for the inflation rate is specified, but no time frame for correcting deviations from target is laid down.

This ''incomplete contract'' clearly creates a potential threat to the Bank''s independence. It also creates the opposite possibility that the Bank will pursue inflation stability at the expense of high output stability. But Bean concludes that there are a sufficiently robust set of supporting arrangements to ensure that the Bank behaves in a ''sensible'' fashion: a non-voting Treasury representative on the MPC, open letters, publication of minutes and the role of the Treasury Select Committee in holding the Bank to account for its actions.

In the final article, Professor Mike Artis, Paul Mizen and Zenon Kontolemis ask whether there are any lessons that the ECB can learn from the new UK arrangements. For example, should the ECB adopt an inflation target? If so, which inflation rate should be tracked? What should be the target period? Should the ECB have both goal and instrument independence?

The researchers note that the notion of an inflation target is more complicated for the ECB given that there are a significant number of nation states involved and some members of the EU are not in the first wave. It may be that no single summary measure is adequate and that as with the new MPC arrangements, information on the target is supplemented by information of probability distributions regarding outcomes.

With regard to openness and accountability, these researchers see obvious practices that the ECB could adopt from the new UK arrangements, but also a need to build in flexibility. Ultimately, however, they argue that the key lesson to be learned from recent experience with central bank independence and inflation targeting is that central banks should ''do what they say and say what they do''!

Having been in place for only a year and a half, the new monetary policy arrangements in the UK are clearly too recent to contemplate a full-scale appraisal. But as this Policy Forum indicates, they are working reasonably well, perhaps better than many anticipated given their radical nature. We will not know whether they have actually delivered a more stable inflationary environment for some time to come.

This Policy Forum on ''The New Monetary Policy Framework in the UK'' is published in the November 1998 issue of the Economic Journal.