The post-ERM Framework for Monetary Policy in the United Kingdom: Bounded Credibility

Abstract

Since the United Kingdom center the Exchange Rate Mechanism (ERM) of the European Monetary System in September 1992 the monetary authorities have constructed an alternative framework for monetary policy which involves a new inflation target and a greater degree of autonomy for the Bank of England. This paper assesses the new framework by examining what it consists of and the way in which it appears to have operated so far, against the background of the problems previously experienced with monetary and exchange rate targets. Section II provides some background information. Section III explains the new framework for policy constructed in the aftermath of the sterling crisis. Section IV offers an evaluation of that framework. Section V presents the conclusions. The new framework follows a period during which both monetary and exchange rate targets had been tried, but had been seen to have failed. Monetary targets were introduced in the United Kingdom during the sterling crisis of 1976, and given greater importance in the Medium Term Financial Strategy from 1980. However, there were repeated overshoots of the targets, particularly during the 1980s, partly as the result of external factors – velocity and other shocks, partly driven by financial innovation – and partly because the authorities themselves chose the target ranges ex ante in arbitrary ways (Cobham, 1989). At the same time their ability to control monetary growth was weakened by the abandonment of the corset in 1980 and the technique of overfunding in 1985, the effects of both of which had been to some extent cosmetic in any case. Monetary targets were therefore abandoned, in practice in 1985 and formally in the 1987 Budget.