Bank of England

The Bank of England (BoE) was founded in 1694 as the government's banker and debt manager. There have been a number of key moments in the BoE's history. In 1781 the renewal of its charter was described as "the public exchequer". The 1844 Bank Charter Act gave the BoE the sole monetary authority in the United Kingdom and tied its note issue to the BoE's gold reserves. Later in the nineteenth century the BoE took on the role of lender of last resort. In 1946 the BoE was nationalized and remained the HM Treasury's adviser, agent, and debt manager. Operational independence was granted to the BoE in May 1997, whereby it undertook the responsibility of monetary policy while public debt management was transferred to HM Treasury and its regulatory functions were passed to the then newly established Financial Services Authority (FSA). The Financial Services Act of 2012 created new regulatory reforms for the BoE whereby an independent prudential regulator was established, the Financial Policy Committee (FPC), as a subsidiary of the Bank. The Prudential Regulatory Authority (PRA) was also created and is responsible for the prudential regulation and supervision of banks, building societies, insurers, and major investment firms. The reforms came into effect on 1 April 2013, with the FSA becoming the two separate regulatory authorities just mentioned.

In September 1992 the UK was forced out of the European Exchange Rate Mechanism. In October 1992 an inflation targeting regime was introduced. In May 1997 that regime was changed to a new one, which was more in line with the policy implications of what has come to be known as the New Consensus Macroeconomics (see, for example, Arestis, 2007). I explain the two regimes in what follows, before I turn to more recent devel- opments as a result of the August 2007 subprime crisis and the Great Recession that followed.

The 1992-97 inflation targeting regime had the following characteristics: (i) 1-4 per cent inflation target; (ii) regular meetings between the Chancellor of the Exchequer and the Governor of the BoE to decide the level of the rate of interest; (iii) publication of the minutes of those meetings began in 1995; and (iv) an Inflation Report began to be published annually in 1993. There were disagreements between the Chancellor and the Governor of the BoE, which affected the credibility of the scheme.

In May 1997 the BoE became independent with operational responsibility given to its Monetary Policy Committee (MPC). The inflation target was set at 2.5 per cent, with a 1 per cent tolerance range of the Retail Price Index excluding mortgage interest payments (the so called RPIX). It was changed to the Harmonized Index of Consumer Prices (HICP) at 2 per cent, with a 1 per cent tolerance range, in October 2003. RPIX excludes mortgage interest payments, but includes council taxes and other housing costs. The inflation target is symmetrical; that is, deviations below the target are treated in the same way as deviations above the target. The MPC meets at least once per month to set the rate of interest (and six times a year to set research priorities). The objective of inflation targeting is price stability; not an end in itself but to help government in its objectives that include growth and employment. The rationale for inflation targeting is that inflation is a monetary phenomenon, and as such inflation should be controlled through the rate of interest. Credibility is attained through pre-commitment to the inflation target without government interference. The idea behind inflation targeting is that it is a constrained- discretion type of policy: it is based neither on pure discretion nor on rules.

The membership of the MPC is as follows: Governor and two Deputy Governors of the BoE; two BoE members (appointed by the Governor of the BoE in consulta- tion with the Chancellor of the Exchequer); four external members (appointed by the Chancellor of the Exchequer); and one Treasury representative who attends and speaks but has no right to vote. The Treasury representative sits at the MPC meetings. An impor- tant dimension of the inflation-targeting set-up of the BoE is the letter to the Chancellor, which the Governor of the BoE would have to write when the inflation target is not met. The Governor's letter to the Chancellor should explain: the reasons why actual inflation is far away from the target; the policy action to deal with it; the period in which inflation is expected to return to target; and how this approach meets the Government's objectives for growth and employment. A second letter is required if, more than three months after the first letter, inflation remains 1 per cent above or below the inflation target. Such an open letter does not necessarily imply a sign of failure.

The MPC is accountable to Parliament, and scrutiny is exercised by a Treasury Committee and the House of Lords Select Committee. However, the government retains overall responsibility for monetary policy: the government is responsible for designing the framework and for setting the inflation target; and once the inflation target is set, it becomes primarily a technical issue as to what level of interest rates is appropriate to meet the target. The MPC is responsible for setting the appropriate interest rate to meet the set inflation target.

The interesting question is whether UK inflation targeting has been successful. Figures for the rate of inflation between October 1992 and August 2007 (before the global finan- cial crisis emerged and the inflation targeting regime was changed as I explain below) support the view that it has been. However, a number of problems exist, as argued by Angeriz and Arestis (2007): actual inflation rates were below the mid-point target, imply- ing tight monetary policy; insufficient attention was paid to the exchange rate; countries that do not have an inflation targeting regime have done as well as the United Kingdom; monetary policy should be concerned with asset price targeting; and the transmission mechanism of monetary policy has changed.

With the Great Recession emerging, the MPC reduced the rate of interest substantially and designed new policies, essentially injecting massive liquidity into the system. The MPC reduced the policy interest rate six times beginning in October 2008 to an all-time low of 0.5 per cent in March 2009 - where it is at the time of writing. A new Banking Act came into force in late February 2009, giving greater powers of intervention to the BoE. The purpose of this Act is for the BoE to be able to give support to stricken banks for financial stability objectives. Most importantly, under the New Banking Act there is a new and permanent provision, the Special Resolution Regime, that for the first time gives the BoE the statutory objective to promote domestic financial stability. Also the introduction of the Asset Purchase Facility (19 January 2009), a framework that enables the MPC to initiate Quantitative Easing (QE), was implemented on 5 March 2009. The ultimate objective of QE is to influence the set inflation target. This is to be achieved via the output gap, influenced by changes in the money supply with its impact on current output, since the BoE interest rate is close to zero. The impact on the output gap and on inflation expectations will achieve the set inflation target.

There are doubts about the effectiveness of QE but one advantage is clear: QE made it easier for the government in its fiscal policy, because it provided a ready buyer for govern- ment debt. Without QE there would have been difficulties, which may have forced the UK government to contain further the degree of its fiscal initiative.

Even more recently the new Governor of the BoE has initiated a new strategy, called "forward guidance". This amounts to explicit guidance in terms of the future conduct of monetary policy: the MPC will not consider raising the policy rate of interest before the unemployment rate has fallen to 7 per cent or below. However, this strategy could be put aside, if inflation exceeds the 2.5 per cent target over the medium run. It is also possible for the BoE to undertake more QE, if additional monetary stimulus is warranted.

See also:

Banking supervision; Central bank independence; Consumer price indices; Financial crisis; Financial instability; Forward guidance; Inflation measurement; Inflation target- ing; Lender of last resort; Money supply; Output gap; Quantitative easing; Rules versus discretion; Zero interest-rate policy.