David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

22. 7 The Monetary Policy Committee
(b) How much spare capacity - for output and for labour - is likely now to be left in emerging Asian markets?
(c)
What does this imply about the likely course of future monetary policy in these countries?
( d) Why was Australia driven to act even more quickly?
(e)
If energy, food and commodities prices rise sharply, what dilemma will then face policy makers in
Europe, the US and Japan?
To check your answers to these questions, go to page 687 .
Mila
.,
The Monetary Policy Committee
_ _ _ _ _
Since 1997 UK interest rates have been set by the Bank of England's Monetary
Policy Committee (MPC), which meets monthly to set interest rates to try to hit
the inflation target laid down by the Chancellor. Initially, the target was 2.5 per
cent annual inflation, plus or minus 1 per cent. The target applied to underlying
inflation (which ignores mortgage interest rates) not headline inflation.
Why omit mortgage interest from the price level on which monetary policy should
focus? Suppose inflation is too high. To reduce aggregate demand, interest rates
are raised. But higher interest rates raise the RPI by raising the cost of living for
homeowners. Moreover, when temporary changes in interest rates are required to
Underlying inflation is the
growth of the retail price index
(RPI), after omitting the effect
of mortgage interest rates on
the cost of living (hence the
abbreviation RPIX).
Headline inflation is actual
inflation, the growth in the RPI.
get the economy back on track, it may also be more sensible to target the underlying rate of inflation.
Different countries construct price indexes in slightly different ways. EU countries
have each adopted a common procedure for calculating their consumer price
index (CPI), making cross-country comparisons of inflation more meaningful. In
December 2003, the UK Chancellor, Gordon Brown, instructed the Bank of England
to switch from using the RPIX to using the CPI as the basis for inflation targeting.
CPI inflation measures the
rate of growth of an index of
consumer prices.
For statistical reasons, CPI inflation tends to grow less rapidly than RPIX inflation. At the time of the
crossover, UK inflation was 2.9 per cent measured by the growth rate of the RPIX but only 1.3 per cent
measured by the growth rate of the CPI. Hence, Gordon Brown also changed the target inflation rate from
2.5 per cent growth in the RPI to 2.0 per cent growth in the CPI.
The quarterly Inflation Report includes the famous fan chart for CPI inflation.
Figure 22.8 shows the fan chart for February 2010. The darker is the projected line,
the more likely the outcome. Figure 22.8 shows that, in August 2007, the Bank was
expecting UK inflation to average around 2.5 per cent in 2007, and then to revert
to the 2 per cent target (with most possible outcomes within 1 per cent of this).
A fan chart indicates
the probability of different
outcomes.
In this section, we discuss three questions. Why was the MPC given a target for inflation? How does it
work? How easy was it for the MPC to decide where to set interest rates?
Inflation targets
Without a nominal anchor, nothing ties down the price level or any other nominal variable. Market forces
only determine real variables.
Nominal money is a possible nominal anchor and is attractive as an intermediate target because new data
on money come out faster than data on prices or output. Monetary targets fell out of favour because large
and unpredictable changes in real money demand made it hard to know where to set the nominal money
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