Inflation Targets and Measurement

1. Inflation Targets and Measurement A2 Economics

2. Central Banks and Targets • Price stability is the primary objective for monetary policy and subordinates other potential objectives • European Central Bank (HICP of 2% or below) • Bank of England (consumer price inflation of 2.0%) • UK introduced inflation targets in 1992 • A dual mandate recognizes two objectives-price stability and full employment-and puts them on an equal footing • Federal Reserve of the United States • No explicit numerical target for inflation • Seeks to achieve sustained growth and price stability

3. Points and Ranges • The inflation target is sometimes set as a point and sometimes as a range • In most cases, the inflation objective is set for a measure of overall consumer price inflation • The time period prescribed for return to the inflation target following departures is sometimes explicit and sometimes not, generally in the range of eighteen months to two years.

4. The UK Inflation Target • Article 11 of the Bank of England Act • Sets the objectives for monetary policy as "to maintain price stability" and • "subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment." • The target, set by the Chancellor of the Exchequer is currently 2.0% for the consumer price index • The Governor of the Bank of England must write a letter to the Chancellor if inflation deviates by more than 1 percentage point from the target • This last happened in April 2007 when CPI inflation reached 3.1%

5. Why Have an Inflation Target? • Widely agreed that low and stable inflation is desirable • Macro-economic stability should lead to higher levels of capital investment and economic growth in the future • Gains from an explicit inflation target: • Improved accountability of monetary policy – the general public can see for themselves whether the target is being achieved • Credible target lowers expectations of inflation – helps to control the growth of wages (the inflation target is an “anchor”) • This can help to improve the trade-off between inflation and unemployment • Lower expectations of inflation help to lower long term interest rates – makes it easier for companies and governments to borrow

6. Inflation Targeting and the UK Economy • 1990s • October 1990-September 1992: Membership of the EU Exchange Rate Mechanism (explicit exchange rate target) • October 1992: Sterling outside of the ERM, Government introduced an inflation target as a new “anchor” for domestic monetary policy • May 1997: New Labour Government gives operational independence to the Bank of England – but still sets the inflation target • 2004 onwards • Change to the inflation target away from RPIX and to consumer price index inflation of 2.0%

7. Meryvn King on the NICE decade • The new monetary framework—based on an explicit target for inflation, a high degree of transparency, and, since 1997, independence of the Bank of England—made it clear to everyone that monetary policy was, and would continue to be, targeted on maintaining low and stable inflation.

8. Consumer Price Inflation in the UK

9. Inflation targets and macro policy • There are dangers in having a narrow inflation target: • Economy might be hit by an external shock e.g. rising food prices which could take inflation above target • If policy response is too deflationary this might make a possible slowdown / recession worse • The Monetary Policy Committee seems to have taken a flexible / pragmatic approach to the recent rise in commodity prices – waiting to see how strong were the inflationary effects • They have reduced interest rates slowly – but the fall in the exchange rate has boosted the effects of monetary policy on demand, output and jobs • But they are determined to avoid a wage price spiral which might hit the credibility of UK monetary policy

10. RPI and CPI • CPI measure of inflation has come in for criticism • RPI measure is consistently higher partly because it includes mortgage interest payments • Loss of confidence among people that the ‘official measure of inflation’ accurately reflects their own experiences of inflation • Government has introduced a ‘personal inflation calculator’ for people who want to find out more • http://www.statistics.gov.uk/pic/

11. RPI and CPI Inflation

12. Richer or poorer? The inflation measurement debate • It is impossible to find an exact measure of inflation – which is the % change in the cost of living using a particular basket of goods • Official measure of inflation is a weighted price index – weights based on spending patterns • But no one is the ‘average consumer’! – there are many different demographic groups • Housing costs are left out of the CPI – and for millions of homeowners this can take up a huge % of their monthly budget • Pensioners spend a higher proportion of their bills on energy, food and fuel • Other groups living at home with their parents, spending their money on DVDs, iPods and imported clothing might actually have a negative inflation rate!

13. Weights used in the CPI

14. Limitations of the consumer price index The CPI is not fully representative Since the CPI represents the expenditure of the ‘average’ household, it may be inaccurate for the ‘non-typical’ household The Changing Quality of Goods and Services Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good is updated reflecting improvements in dynamic efficiency in the market-place