The United Kingdom followed Canada in adopting inflation targeting, but under quite different circumstances. In discussing its experience, we focus on the following themes:
* Like the other countries examined, the United Kingdom adopted inflation targets after a successful disinflation. Unlike these countries, however, the United Kingdom took this step in the aftermath of a foreign exchange rate crisis in order to restore a nominal anchor and to lock in past disinflationary gains.
* In the United Kingdom, there is less attempt to treat inflation targeting as a strict rule than in New Zealand, making the targeting regime more akin to the German and Canadian approach.
* As in the other inflation-targeting countries, monetary policy in the United Kingdom also responds flexibly to other factors, such as real output growth.
* Like Canada, but unlike New Zealand, the United Kingdom separates the entity that measures the inflation target variable (Office for National Statistics) from the entity that assesses whether the target has been met (the Bank of England).
* In the United Kingdom, the headline consumer price index (CPI) is not used in constructing the inflation target variable; the target variable excludes mortgage interest payments, but does not exclude energy and food prices or other adjustments.
* Initially, the Bank of England targeted an inflation range, but then shifted to a point target.
* Because the British central bank lacked independence until the May 1997 election, it was accountable for meeting the inflation targets but did not fully control decisions about the stance of monetary policy.(1) Indeed, up until May 1997, the Bank was limited to providing the principal forecast of inflation and assessing past inflation performance. As a result, the Bank functioned as the Chancellor of the Exchequer's counterinflationary conscience.
* In part because of its weaker position before May 1997, the Bank of England focused its inflation-targeting efforts on communicating its monetary policy strategy and its commitment to price stability, relying heavily on such vehicles as the Inflation Report, an innovation that has since been emulated by other inflation-targeting' countries.
Although the relationship between the Bank of England and the Chancellor of the Exchequer has now changed, the United Kingdom's targeting framewor-k- prior to the granting of independence in May 1997 is an important example to consider in the design of inflation-targeting frameworks in general. (We briefly discuss the post-May 1997 regime at the end of this case study.) In particular, our analysis indicates that the split between the monetary policy decision maker and the primary public inflation forecaster had significant implications for the performance of U.K. monetary policy between October 1992 and May 1997; future actions of the newly independent Bank of England will support or disprove our belief about the importance of this relationship to target performance.
ADOPTION OF THE INFLATION TARGET
The Chancellor of the Exchequer, Norman Lamont, announced an inflation target for the United Kingdom at a Conservative Party conference on October 8, 1992.(2) Three weeks later, at his annual Mansion House Speech to the City (Lamont 1992), he "invited" the Governor of the Bank of England to publish a quarterly Inflation Report detailing the progress being made in achieving the target, an invitation that the Governor accepted.
The adoption of a target was an explicit reaction to sterling's exit from the European Exchange Rate Mechanism (ERM) three weeks before. The Chancellor wished to reestablish the credibility of the government's commitment to price stability, which had seemed to gain from the pound's two years in the ERM (as primarily measured by interest rate differentials with Germany and spreads in the U.K. yield curve). Given the United Kingdom's history of trying and abandoning a series of monetary regimes in the post-Bretton Woods period, there was considerable potential for damage to credibility, both at home and abroad, from the aftermath of the Black Wednesday foreign exchange crisis in September 1992 and a currency devaluation of more than 10 percent. …