Inflation Targeting in the United Kingdom: Information Content of Financial and Monetary Variables

Inflation targeting is the monetary strategy of all EU member states; whether in the euro area, the two euro-outs, Sweden and the United Kingdom. The latter are now faced with two alternatives to achieve price stability: either remain outside the euro area or join it as full-fledged members. This paper examines this policy choice starting from the views of Knut Wicksell, who considered it in his 1920s analysis of an international monetary system based on price level targeting. Price stability could be achieved either within every country by maintaining flexible exchange rates or jointly on a global scale through a system of fixed exchange rates, that is through a monetary union. To him this was a choice between two ‘evils’: fluctuating price levels in the member states of a global monetary union while the average price level is maintained constant versus fluctuating exchange rates in the absence of a monetary union. To Wicksell, the choice of the proper route towards price stability was less complicated than today because he analysed it solely in monetary terms. The current choice for Sweden and the United Kingdom involves other crucial dimensions, such as the existence of nominal rigidities, and the politics of domestically issued money. Political aspects concerning the euro will be the ultimate determinants of the future monetary path for both countries.

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HOW DOES MONETARY POLICY CHANGE? EVIDENCE ON INFLATION-TARGETING COUNTRIES

Macroeconomic Dynamics ◽

10.1017/s1365100512000545 ◽

2013 ◽

Vol 18 (3) ◽

pp. 593-630 ◽

Cited By ~ 17

Author(s):

Jaromír Baxa ◽

Roman Horváth ◽

Bořek Vašíček

Keyword(s):

Monetary Policy ◽

United Kingdom ◽

Interest Rates ◽

Inflation Targeting ◽

Inflation Expectations ◽

Time Varying ◽

Policy Rules ◽

Monetary Policy Rules ◽

The United Kingdom ◽

Endogenous Regressors

We examine the evolution of monetary policy rules in a group of inflation-targeting countries (Australia, Canada, New Zealand, Sweden, and the United Kingdom), applying a moment-based estimator in a time-varying parameter model with endogenous regressors. From this novel flexible framework, our main findings are threefold. First, monetary policy rules change gradually, pointing to the importance of applying a time-varying estimation framework. Second, the interest-rate smoothing parameter is much lower than typically reported by previous time-invariant estimates of policy rules. External factors matter for all countries, although the importance of the exchange rate diminishes after the adoption of inflation targeting. Third, the response of interest rates to inflation is particularly strong during periods when central bankers want to break a record of high inflation, such as in the United Kingdom or Australia at the beginning of the 1980s. Contrary to common perceptions, the response becomes less aggressive after the adoption of inflation targeting, suggesting a positive anchoring effect of this regime on inflation expectations. This result is supported by our finding that inflation persistence typically decreased after the adoption of inflation targeting.

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