U.K. Inflation Targeting and the Exchange Rate

Abstract

The United Kingdom*s monetary policy strategy is one of floating exchange rates and inflation forecast targeting, with the targeted measure referring to consumer prices. We consider whether it is welfare-reducing to target inflation in the CPI rather than in a narrower index; and the role of the exchange rate in the transmission of monetary policy actions to CPI inflation. We argue that it is appropriate to model imports as intermediate goods rather than as goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy, while also offering a sustainable explanation fore the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target.