Favorable Experience: United Kingdom's Targeting Framework Is Expected to Improve Inflation Performance

• Author: Timothy D. Lane
• Position: IMF European I Department
• Pages: 78-80

Page 78

For more than five years, the United Kingdom has relied on inflation targeting to set its monetary policy. Inflation targeting-which began in October 1992-has ushered in a period of moderate inflation. The officially targeted measure-retail price inflation (excluding mortgage interest)-stayed close to its 21/2 percent target and reached the target in April 1997 (see top chart, page 79). Soon after taking office, the Labor government granted the Bank of England operational independence, while preserving key elements of the inflation-targeting framework and establishing additional elements of accountability. The result appears to be increased credibility for U. K. monetary policy, as evidenced by declining expected inflation and diminished spreads on bond yields.

Logic of Inflation Targeting

Under inflation targeting, the central bank sets a target for inflation and focuses monetary policy on achieving this target. The process is inherently forward-looking: monetary policy affects inflation only with a lag, which in the United Kingdom has been estimated at 18 months to two years, but maybe even longer. As a result, inflation targeting can be seen as using the authorities' inflation forecast as an intermediate target: the authorities set monetary policy instruments so that inflation is predicted to be at its target-tightening if it is forecast above the target, easing if it is below.

The forward-looking nature of inflation targeting- unlike other forms of monetary targeting-makes it inherently nontransparent, thus creating a need for compensating institutional features to enhance the transparency of the policymaking process. The link between monetary policy and inflation is complex, prolonged, and uncertain. In contrast, with an exchange rate target, monetary policy is typically transmitted almost immediately to foreign exchange markets, and it is readily appar-Page 79 ent when a target has been breached. With monetary aggregates as targets, the degree of transparency is somewhere in between: interest rates affect monetary aggregates with a relatively short lag, and these aggregates can be monitored on a monthly basis.

Given the fact that inflation targeting is inherently less transparent, it is particularly important that certain elements of it be stated clearly. These include the inflation targets, the horizon over which they will be met, and the basis on which...