The beginning of a new consensus in the UK (1992-1997)

After the failure of the exchange rate mechanism in early 1992, the UK stayed in front of a difficult task which required an immediate action. As a resolution to the situation, the Chancellor Norman Lamont introduced five alternative policies– cutting the interest rates and sustains the parity, devaluation within the ERM, German realignment and leaving the ERM, cutting the interest rates or the last one leaving the ERM and setting interest rates according to domestic indicators (Lamont, 1993). In 1992, after the UK left ERM, the UK’s Government declared the longer-term objective formulated as “price stability”, or in other words the defeat of inflation on a lasting basis. However, the exact explanation of what exactly this formulation of low inflation means was not specified as the objective was to hold the inflation on a permanently as low rate as the best of the other countries in the Europe. In fact, the UK aimed to achieve the same inflation level as Germany. However, this objective was not achieved (Figure 3.8) even it was assumed by the government that lower inflation of 2 per cent in 1996-1997 could be achieved by inflation measured by the GDP deflator, the same measurement as used in Germany.

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Figure 3.8: Annualized inflation rate (1987-1994)

Source: Adapted data from HM Treasury (1992a)

Neither different measurement did not have expected effect therefore the objective of holding the inflation on a permanently as low rate as the best of the other countries in the Europe was not achievable. In his letter from 24 September 1992 the Chancellor Norman Lamont (HM Treasury, 1992b) explains that the forecast shows that inflation in the UK should match inflation in Germany during the years 1993-1995, and suggested holding inflation in the range of 3-4 per cent over the next two years. However, he also points out that a significant tightening of policy will be necessary in order to match inflation in Germany. This was the beginning of a new policy approach, based on a revolutionary framework of conducting the policy as a systematic response to incoming information about economic conditions introduced by Taylor (1993), nowadays known as the Taylor rule. The Taylor rule suggests that policy makers should set the nominal interest rate as a function of deviations of inflation from target and deviations of the level of real output from its trend (Kahn, 2012).

The original Taylor rule can be written as:

Rt = (r*+*) + 1.5(pt - *) + 0.5(yt - yt*) (3.3)

Where Rt is the nominal interest rate, pt represents the inflation rate and (y - y*) is the

deviation of the output from its trend level, thus the output gap, * is the target inflation and r* represents the real interest rate. Nevertheless, even though the purpose of the Taylor rule was to describe the setting of monetary policy in the U.S and it fits the data empirically, it says only little about what information policymakers actually respond and how they make decisions (ECB, 2011). According to Belke and Klosen (2011) policy decisions cannot be made solely on inflation and output, but the policy needs to be conduct using additional information such money growth, asset prices as well as commodity prices.

2.76 15.58 2.85 5.34 9.64 5.59 2.89 2.62 _1.91 4.59 0 2 4 6 8 10 12 14 16 18

France Greece Ireland Italy Portugal Spain Austria Germany Netherland UK

In

flat

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At the meeting on the new monetary framework on 2 October 1992 (HM Treasury, 1992b), one of the main concerns discussed was the improvement of credibility of policy. Inflation target was suggested to be from 0 to 4 per cent because of the previous errors and variations in the forecast. However, the Chancellor Norman Lamont strongly refused including zero inflation into the objective as he hoped to move away from zero inflation before sterling’s membership of the ERM had been suspended as it seemed to be unachievable (HM Treasury 1992a). Therefore, a target at a range of 0-4 per cent as the upper end of the range was refused as according to Chancellor Lamont did not reflect an ambitious performance. A few of days after the meeting, in 8 October 1992, the Chancellor Norman Lamont sent a letter to the Chairman John Watts in order to set out the Government’s policy as it required an immediate action. In his letter he states that the Britain can rejoin ERM under the condition that current turbulence in the foreign exchange markets ends and more importantly when German and UK monetary policy will be “in line” (Lamont, 1992).

“In the Government’s view these conditions are unlikely to be satisfied soon therefore we need to establish a framework for monetary policy to replace that hitherto provided by the

ERM.”

The Chancellor Norman Lamont

Even the Chancellor showed his averse to range of 0-4 per cent, in the letter from 5th October 1992 to the Chairman John Watts he stated the objective of keeping inflation rate within a range of 1-4 per cent with an aim to be in the lower part of the range. In this letter, the Chancellor also clearly presents that the UK suffers from price stability for more than a generation and in order to achieve a price stability he suggests to measure inflation by the change in retail prices excluding mortgage interest payments and express an aim at a long term rate of inflation of 2 per cent or less (HM Treasury, 1992b). As stated in the letter from 1 October 1992 to the Chairmen that individual variable has to be target as targeting more than one measure will reduce credibility and even GDP deflator seems to be a better indicator of inflation than RPI, he argues that RPI has fallen more than the GDP deflator over the past years. On the other hand he points out that none of the indicators is ideal as according to Norman such an indicator does not exist and needs to be created (HM Treasury, 1992a). It should be noted that the Taylor rule does not dominate in the policy framework of the BoE however plays a background role (Nelson and Nikolov, 2004). Nevertheless, expectations were high as taking the control over inflation seemed to be an illusion more than a reality

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when considering that the UK did not experience stable inflation over a generation before inflation targeting. The fear of losing the credibility achieved by joining ERM shifted into reality however, it was only an immediate effect and lost credibility was according to Chancellor’s speech to the European Policy Forum in 29 July 1993 again achieved by the announcement of a new monetary policy framework and including inflation target of 1-4 per cent (Lamont, 1993). As a result of the ERM membership the retail price inflation dropped from 11 per cent to 4 per cent, interest rates were cut from 15 to 10 per cent and trade deficit with European countries had fallen from 11 billion GBP in 1990 to 2 billion GBP in 1991 (Lamont, 1993). In the speech from 29 July 1993 the chancellor evaluated situation one year later after leaving the ERM as previous forecast about dramatic economic consequences of leaving the ERM showed wrong and the UK was enjoying low interest rates and inflation, improved competitiveness and an economic recovery, however the unemployment was still higher.

3.8.2 The Bank of England’s operating independence and pre-crisis period