Coursework

The history of monetary policy strategies

For the first part of post-war period, monetary policy was designated only a marginal role in the control of aggregate demand. In line with Keynesian principles, fiscal policy was seen as the primary tool of macroeconomic stabilisation, while interest rates were to be set low to encourage investment and credit controls employed to restrain consumer borrowing.

If excess demand pressures showed signs of spilling over into higher inflation and a deteriorating balance of payments, then incomes, rather than monetary policy was the chosen tool to keep those pressures in check. When they turned out to be unsuccessful, resort would be made to devalue the pound in order to restore competitiveness.

Monetary targets were first adopted by the Labour Chancellor Denis Healy, in 1977, and in 1979 became a centrepiece of Margaret Thatcher’s government’s macroeconomic strategy. Monetary targets proved to be unreliable guide to the conduct of monetary policy during the 1980’s, however, on account of unpredictable movements in the velocity of circulation. The first chosen target aggregate was a broad aggregate including sterling time deposits with the banking sector. In order to reduce inflation, the target ranges were set at 7 – 11% for 1980, and 6 – 10% in 1981; the result ended up being 18.4%, and 16.3% respectively. But other indicators did not point to monetary laxity, with narrow money growth slowing from 12.1% in 1979 to 2.6% in 1981. And monetary policy tightness was reflected in other developments in the economy: sterling rose by around a quarter, while output dipped more than 3% leading to a subsequent sharp fall in inflation.

Through the second half of the 1980’s, the then Chancellor of the Exchequer, Nigel Lawson, pursued an informal exchange rate peg by shadowing the Deutsche Mark. This evolved into a formal exchange rate target when the sterling entered the ERM in 1990 at 2.95DM to the pound; a rate was felt in some quarters as perhaps a little high. But that suited the government because it permitted lower interest rates, which was considered by the government at the time a sensitive matter in the United Kingdom on account of the prevalence of flexible rate mortgages, while still restraining inflationary pressures. The risks inherent with this strategy were brought home when the economy subsequently slowed sharply at exactly the same time as pressures of the German re-unification were pushing European interest rates upwards. Eventually tensions between following a tight policy in order to maintain the exchange rate peg and the desire to limit the domestic downturn by lowering interest rates became so great that the government’s policy ceased to be credible, resulting in speculative attacks on sterling and the decision to quit the ERM on 16th September 1992.

There was now an urgent need for an alternative framework for the conduct of monetary policy. Monetary targets, and intermediate targets more generally, were seen to have failed because of the lack of a predictable relationship with the ultimate goal of policy. Furthermore, shifts in the relationship between the intermediate target and the policy goal not only complicated the conduct of policy but also it communication. Additionally, advances in economic understanding might well lead to a changed view on the most appropriate intermediate target. An inflation target offered a way out of impasse. And by defining the framework in terms of the objectives of monetary policy, an inflation target allowed the strategy for its actual implementation to evolve without requiring continual re-specification of the framework. The target measure was the Retail Price Index excluding mortgage interest payments (RPIX), with a target range of 1% - 4% and the intention that it should be in the lower half of that range by the end of that parliament (scheduled to be in 1997).

It is worth emphasising that the adoption of an inflation target was also accompanied by important institutional changes. For the achievement of a measure of macro-economic stability in the subsequent decade has probably less to do with the adoption of an inflation target, and probably more to do with associated institutional changes. Prior to the adoption of an inflation target, interest rate decisions were often taken in response to a crisis or else with half an eye on political considerations. By instituting a regular monthly meeting between the Chancellor and the Governor of the Bank of England and their respective advisory teams, there was a greater chance that policy decisions might be made in a forward-looking manner rather than purely reactive way. More importantly, the decision to publish minutes of the meeting (dubbed the Ken and Eddie’ show by the media) exposed the thinking behind decisions and thereby allowed the Governor to register disapproval of the Chancellor’s decisions inappropriate (the actual decision was in the hands of the Chancellor). This provided a highly visible check on the monetary decisions of the executive, and was reinforced by the publication by the Bank of a Quarterly Inflation Report containing analysis of the Inflationary trends in the economy, including forecasts of inflation over a two-year horizon complete with estimates of margins of error.