UK Monetary Policy

UK Monetary Policy

Although monetary policy can be used to affect many things, the main objective of monetary policy is the control of inflation. The current target for inflation set by the government is 2.5% (using the RPIX measure), although it is allowed to deviate 1.5% either way (so the allowable band is 1% - 4%).

Ever since the UK fell out of the Exchange Rate Mechanism (ERM) in September 1992, UK monetary policy has involved using interest rates to control the level of inflation.

It has not always been this way. As the term 'monetary' suggests, another form of monetary policy is the control of the money supply. It was believed that by controlling the money supply the price level would be controlled as well. This was the main method used to control inflation during the Thatcher's 'monetarist experiment' of the early 80s.

There are very close links between the rate of interest, the money supply and the exchange rate. At times when the UK has been tied to a fixed exchange rate system (like the Bretton Woods system after the Second World War, and, more recently, the ERM), both the rate of interest and the supply of money have to be adjusted to maintain the goal of the fixed exchange rate. When the UK was part of the ERM from 1990 to 1992, the UK government effectively lost control of interest rates and, to a certain extent, the supply of money.

So, a government's monetary policy consists of the control of interest rates, the money supply or the exchange rate. It is difficult to control two or more of these things at once.

The policy of controlling the money supply of the early 80s did not quite work as intended. Nigel Lawson, the Chancellor at the time, decided to 'shadow' the Deutschmark (DM). From 1987, he decided that the UK should 'pretend' to be in the ERM. The idea of fixing the £ to the DM was that inflationary devaluations would not be possible, so inflation should be kept under control. Also, as industry could not rely on a fall in the value of the £ to restore competitiveness, they would simply have to become more efficient. The higher value of the £ would impose discipline on UK industry, and hopefully UK inflation would be forced down to the level of Germany's.

Of course, in the late 80s, the consumer boom out-weighed any deflationary effects of a stronger £. Inflation rose and interest rates rose to 15%. Did the UK have a monetary policy based on the exchange rate or interest rates? Thatcher wanted to use interest rates. Her belief in markets made it hard for her to accept controls on the value of the £ (exchange rates are determined in currency markets after all). For various political reasons, though, her hand was forced and the UK joined the ERM in October 1990.

The £ was now officially fixed against nearly all of Europe's currencies (although its value was allowed to adjust by 6% - it was not a totally fixed exchange rate system). The UK government effectively had no control over their rate of interest. If Germany changed their interest rates, the UK soon followed, otherwise the value of the £ would change. Although nominal UK interest rates fell, real interest rates stayed very high, which was disastrous given that the economy was in a deep recession. The value of the £ was too high. The government knew it and the markets knew it. For most of 1992, the £ was at the bottom of the allowed band within the ERM. The markets were selling the £ and the only buyer was the UK government!

Eventually the pressure was too much. Having spent billions of pounds supporting the £, on the 16th September 1992 the Chancellor raised interest rates from 10% to 12% at lunchtime (a huge rise given today's quarter point changes). The markets laughed, saw it as a sign of weakness and just kept selling. Rates were raised again on the same day to 15%, to take effect the following morning. The selling continued. The UK government threw in the towel and pulled out of the ERM. The £ instantly devalued by 15%. Interest rates went back down to 10% (the same rate as that morning!). The government had lost billions of pounds. This day was known as 'Black Wednesday' although many economists now refer to it as 'White Wednesday' because from that day onwards, interest rates were able to fall further, the value of the £ was much lower and the economy began to recover. For some, the 16th September 1992 was the last day of the 1990-2 recession.

Since 1992, monetary policy has consisted of interest rate changes with a floating £. The new Chancellor in 1993, Kenneth Clarke, set up a system where he would meet the Governor of the Bank of England once a month and discuss whether interest rates needed to be changed. Clarke would still make the decisions, but the minutes of these meetings were published. If Clarke was seen to be disagreeing with the Governor (whose opinion was respected) but did what he wanted anyway, he could be held to account if his decisions were wrong. As in turned out, ironically, the Chancellor tended to get the decisions right, but most economists agreed that the 'Ken and Eddie show' (Eddie George was the Governor of the Bank of England) was a good system.

Four days after the election of the Labour government in May 1997, the new Chancellor, Gordon Brown, made the Bank of England independent. This meant that the Chancellor would no longer make the decisions on interest rates. The Monetary Policy Committee (MPC) of the Bank of England was set up. Although there have been some minor changes along the way, the procedure then is much as it is now.

There are nine members in the committee. Five are Bank of England men (including the Governor) and four are independent economists from the real world. They meet once a month and make a decision that is announced at 12 noon on the first Thursday of every month. Each member has a vote. Should rates go up? Go down? Stay the same? The votes are counted and the majority wins. The minutes of the meeting are published before the next vote so that the general public can see how everyone voted.

Their only objective (set by the government) is to keep inflation at 2.5%, although the inflation rate is allowed to vary between 1% and 4% (i.e. plus or minus 1.5%). In other words, if inflation gets too low that is just as bad as if inflation gets too high. Japan had negative inflation for most of the year 2000, but it didn't do them any good. If inflation is too low the economy is probably in a deflationary mode, causing unemployment and low growth.

If inflation does go over 4% or under 1% then the Governor of the Bank of England has to write an open letter to the Chancellor to explain what he did wrong. There is, therefore, some accountability.