Monetary policy is used to stimulate or slow the real economy in the short run so that the economy is kept as close as possible to its long run potential rate of growth and inflation kept close to its target.

It is important to remember, however, that in the long run, real activity, i.e. economic output, is independent of monetary policy. This general principle is usually referred to as “the long-run neutrality of money”.

Instead, real activity depends on the efficiency of the supply side of the economy. Most notably it depends on how well labour and capital interact and on technological change and population growth.

The importance of maintaining low inflation is that it allows these areas to work more efficiently.

Monetary policy may be conducted through direct controls on the money supply, such as restrictions on bank lending in general and consumer credit in particular, or indirectly through the use of interest rates.

In the UK in the 1950s and 1960s, direct controls were a key feature of monetary policy.

Lending ceilings were imposed with the Bank of England periodically setting guidelines on lending patterns so that borrowing by companies was given precedence over personal borrowing. There were also restraints on hire purchase which were only finally abolished in 1981.

The inherent weakness of using direct controls is that financial institutions are able to circumvent them. Disintermediation, the provision of finance by institutions not covered by the Bank of England’s controls, for instance, led eventually to the introduction of Competition and Credit Control in 1971.

This saw the UK seeking to embrace a more market-related policy with interest rates allowed a greater role in influencing the demand for and supply of money.

Competition and Credit Control, however, was a failure. In the first place, the 1970s saw a huge upsurge in borrowing following the credit rationing of the 1960s.

At the same time the Government’s wish to stimulate the economy out of recession required interest rates to be kept low. In turn this encouraged further borrowing.

The upshot was that direct controls were reimposed via the ‘Corset’ or Supplementary Special Deposit Scheme and the reintroduction of hire purchase controls.

The ‘Corset’ was eventually removed as late as 1980 and hire purchase controls in 1981. Between then and 2009 with the introduction of quantitative easing, UK monetary policy relied solely on indirect controls, namely interest rates.

For much of 2008, above target inflation and worries that it would become embedded in the system meant that Bank Rate, having been cut by a quarter percent in February remained at 5% for the next 7 months.

During the latter months of 2008, however, these worries were overtaken by increasing evidence of a synchronised global downturn combined with concerns about the health of financial systems worldwide. Once this situation was recognised, the Bank of England’s response was drastic with Bank Rate being cut from 5% in September to 0.5% in March 2009.

This easing in policy was the quickest in the Bank of England’s history as a central bank.

Given the weakness of the UK and global economies, the Bank recognised that in order to stop the rate of inflation falling well below the 2% target and even through the bottom of the 1 – 3% range, Bank Rate needed to be reduced to close to zero.

As well as cutting interest rates, the Bank together with the Government introduced various schemes to encourage bank lending without compromising the banks’ efforts to get back on even keel.

A significant part of the problem was that the banking sector was not working properly. To get back in shape, banks were forced to restructure their balance sheets either by raising new capital through rights issues or through accepting part nationalisation by the Government, by selling assets, and by reining back lending (a natural reaction in a deteriorating credit environment).

This necessary adjustment obviously risked restricting the supply of credit, thus making the recession worse.

It was eventually realised, however, that on their own the interest rate reductions and these lending schemes would be insufficient for the Bank to hit its inflation target in the medium term. The result was quantitative easing (QE).

Having reduced the price of short term credit through cuts in Bank Rate, the MPC needed to ensure both that the necessary quantity of credit would be made available and that longer term interest rates would be reduced to come into line with short term rates. QE was the chosen method to achieve those two aims.

Essentially QE is a return to direct controls but whereas in the past direct controls have been used to restrict monetary growth and lending, here they are being used to expand the money supply and bank lending.

They are also seen as a strictly temporary measure which will need to be reversed, in contrast to direct controls in the past which were seen as ongoing policy tools.

A total of £150 billion was allocated for QE in March 2009 a sum which was increased to £175 billion in August and later to £200 billion. The idea was the Bank of England’s Monetary Policy Committee would use as much of this as it thought necessary to buy two types of assets, UK government bonds or gilts and debt issued by private companies.

The sellers of the bonds or debt would then receive funds which they could spend, thus boosting growth. Alternatively they could use the funds to buy other financial assets, in turn providing the sellers of those assets with money to spend or invest.

The key point is that the Bank of England is able, via the electronic creation of money and the purchase of bonds, to increase the potential spending power of the UK private sector.

At the same time the purchase of gilts and corporate bonds, pushes up the price of those assets and causes yields to fall, thus flattening the yield curve (see Interest rates and yield curves) and making it cheaper for businesses and households to borrow longer term funds.

A major risk to the use of QE is that the rapid and large increase in the money supply will eventually feed through to increased inflation, pushing the rate above the Bank’s target and, perhaps, well above.

The key for the Bank of England will be to recognise the point when QE stops being benevolent and the slack in the economy is close to being used up. At that stage, the Bank will need to start raising Bank Rate and removing the excess money supply by selling back the assets it had previously acquired.

Timing will be crucial. Too early and the Bank risks stalling the recovery. Too late and inflation could get out of control.

When normality is resumed and the economy has returned to a sustainable growth path, monetary policy will return to the inflation targeting framework which was used successfully in the period to 2008.

But the lessons of the current economic crisis will need to be taken into account when conducting that policy. In particular, a way will need to be found to counteract asset bubbles, such as occurred in the housing market, and economic imbalances. These have proved to be extremely destabilising and a threat to the Bank’s ability to hit inflation targets.

This is a difficult area. Recognising when a simple market adjustment has turned or is turning into a bubble is challenging. But it is a challenge which must be faced.

It is also unlikely that short term interest rates alone will be sufficient in dealing with such a problem area. The Bank will eager to find a range of instruments to do so.

Central banks which control inflation through the use of instruments such as interest rates, have a variety of strategies from which to pick. They may use intermediate targets, movements in which are thought to have a predictable effect on inflation, or they may target inflation directly.

Strategy one - using money supply as an intermediate target

Central banks may, for instance, use an intermediate target such as the growth in a suitable measure of the money supply.

The rationale is that there is assumed to be a predictable relationship between the particular measure of the money supply being targeted and future inflation as set out in the quantity theory of money.

A target rate of growth is then determined for the monetary aggregate and interest rates are adjusted to achieve that target. Whereas the intermediate target is specific, the final target for inflation is usually described in more general terms such as “low and stable”.

Intermediate monetary targets were introduced by the Labour Chancellor, Denis Healey, in 1977 and were also central to the Conservative Government’s macroeconomic policy from 1979 to the mid 1980s.

Unfortunately, the relationship between money supply and inflation was less apparent in practice than in theory, largely because of the unpredictability of the velocity of circulation.

Strategy two - using the exchange rate as an intermediate target

With the money supply accepted as a poor intermediate target, the focus shifted to using the exchange rate.

The rationale is that by setting its exchange rate against the exchange rate of an economy with a historically strong tradition in controlling inflation, a country shadows the monetary policy of the anchor economy.

Over time this should mean a convergence in the home country’s price level and inflation to the anchor country.

Thus in the second half of the 1980s, the then Conservative Chancellor, Nigel Lawson, informally shadowed the deutschemark, this policy being formalised in 1990 when sterling joined the Exchange Rate Mechanism at 2.95 DM/£.

The 1991-92 Financial Statement and Budget Report noted in March 1991 that monetary policy would “be conducted so as to sustain sterling’s position within its Exchange Rate Mechanism (ERM) bands.

This will ensure that UK inflation moves progressively into line with the best inflation performance elsewhere in the ERM.”

Similar sentiments were expressed in the Budget Statement in March 1992. “The Government is committed to membership of the Exchange Rate Mechanism (ERM) of the European Monetary System, and this provides the framework for monetary policy.”

In fact, within six months of the March 1992 Budget Statement, the UK had left the ERM.

Membership of the ERM became increasingly fraught as external events clashed with UK needs.

German re-unification resulted in higher European interest rates which the UK needed to match if it wanted to maintain sterling’s position within the ERM structure.

Unfortunately, slowing UK activity demanded the opposite – lower interest rates to stimulate the domestic economy.

The two were obviously incompatible and led to attacks on the UK currency by speculators selling sterling on the assumption that it was being kept at an unsustainably high level.

These speculative attacks were sufficient to oblige sterling’s withdrawal from the ERM on 16th September 1992.

Strategy three - targeting inflation directly

Monetary and exchange rate targets having failed, the UK needed a new strategy for monetary policy. The next alternative was to set an explicit final target for inflation.

Inflation targeting usually means setting a target at some period in the future to allow for the lag between interest rate changes and their eventual effect on inflation.

Policy decisions are made on the basis of trends in a number of intermediate variables.

These intermediate variables may also be used as inputs to provide an inflation forecast which then becomes a quasi-intermediate target.

In the autumn of 1992, a new monetary framework was introduced with an explicit inflation target.

The aim of monetary policy was to “keep underlying inflation (as measured by the RPI excluding mortgage interest payments) in the range 1 – 4 per cent, and to bring it down to the lower part of this range by the end of the present Parliament” (Financial Statement and Budget Report, March 1993).

The Report noted that interest rate decisions would be “based on a continuing assessment of monetary conditions, measured principally by the growth of narrow and broad money, and movements in the exchange rate and asset prices.”

As monetary policy evolved over the next few years, the target range was maintained but the range of variables used in assessing the correct level for interest rates was widened.

The 1994-95 Financial Statement and Budget Report noted that “estimates of the extent of spare capacity in the economy and the overall stance of fiscal policy” would also be taken into consideration when setting interest rates.

The Report also explicitly accepted that “monetary policy influences inflation with a lag. Interest rate decisions are therefore based on an assessment of the prospects for underlying inflation in one to two years time.”

The 1995-96 Budget Report in November 1994 noted that decisions on interest rates would be based on monetary and other financial indicators plus indicators of activity and indicators of costs.

The 1996-97 Budget Report a year later commented that “interest rate decisions are not based solely on any one indicator, but on an overall assessment of all the relevant information concerning the prospects for inflation.” This 1996-97 Report was the first to mention a target of 2.5% or less, i.e. the bottom half of the 1- 4% target range.

Even by the 1997-98 Budget, however, monitoring ranges for money supply measures were still set, although, as the Report stated, “interest rate decisions are taken on the basis of all relevant information”.

Within days of the new Chancellor, Gordon Brown, taking office in May 1997, he announced a new monetary policy framework with the Bank of England taking operational responsibility for setting interest rates to achieve an inflation target to be set by the government.

The inflation target, set at 2.5% initially, would be reviewed in each Budget Statement.

Although the Bank of England has always conducted monetary policy, it was until 1997 as the agent of the Government.

Prior to May of that year, changes in interest rates were decided by the Chancellor of the Exchequer and it was the Bank’s role to carry out the operational procedures needed to implement that interest rate change.

Interest rate decisions would be made by a nine strong Monetary Policy Committee (MPC) including the Governor of the Bank, two deputy governors and six other members.

Of those six, two would be appointed by the Governor and four by the Chancellor, all for a term of three years.

The MPC normally meets on the Wednesday afternoon and Thursday morning after the first Monday of the month.

The first day is used to discuss the current economic situation with the following morning reserved for policy decisions which are then announced at noon.

The target introduced in 1997 to replace the previous ‘2.5% or less’ was to be a point target of 2.5%. As with the earlier target, the inflation measure would be RPIX, i.e. retail price inflation, excluding mortgage interest payments.

The new process required that, should the inflation outturn exceed the target by more than one percentage point or undershoot it by more than one percentage point, the Governor would be required to write an open letter to the Chancellor explaining why the divergence had occurred.

The Chancellor also made it clear that the 1% bands were not to be considered as a target range but rather trigger points for the explanatory letter.

The addition of a two-tailed target was an important step forward in monetary policy making because it reduced the temptation to run the economy at below its potential or trend rate of growth for any length of time.

In effect it introduced an implicit growth target alongside the explicit inflation target.

Achieving low inflation per se is relatively easy, merely requiring interest rates to be set sufficiently high to ensure economic activity is consistently below trend.

But the duty of the Bank of England is not only to hit the 2.5% target but also to avoid inflation, at any stage, moving more than one percentage point above or more than one percentage point below that target. That entails ensuring that activity growth remains as close to its trend rate as possible.

In his speech on 9 June 2003 assessing the five tests for joining the European Single Currency, the Chancellor announced his intention to make changes to the inflation target set for the Bank of England.

His aim was to replace the RPIX target with one based on the Harmonised Index of Consumer Prices (HICP), now known as the Consumer Prices Index or CPI (see 8.3 Measuring Inflation - Consumer prices index).

Moving to this measure would, according to HM Treasury, “improve the quality of the UK inflation target and will also ensure inflation expectations in the UK remain in line with those of the euro area.”

Credibility is defined as the ability of a monetary authority to meet its stated objective. For the Bank of England, therefore, it has been achieved by maintaining, firstly, the underlying inflation rate, RPIX, and then the CPI as close to the target as possible.

Transparency is the degree to which economic agents are able to deduce what the authority’s objective and intentions are.

Transparency, by allowing economic agents to recognize fully what the monetary authority is trying to do in terms of its objectives and its policy actions, removes market uncertainty.

At the same time, it helps to build up credibility in what the authorities are trying to achieve and allows monetary policy to work more effectively.

Importantly, in the period between the adoption of an inflation target and May 1997, the Bank of England took a much more transparent role in advising the Chancellor on what rates should be.

Regular monthly meetings between the Governor of the Bank of England and the Chancellor and the publication of the minutes of those meetings meant that observers could see the thinking behind the decision making.

The decision making remained with the Chancellor but the minutes and the Bank’s publication of a quarterly Inflation Report which included inflation forecasts up to two years ahead meant that the Bank’s approval or, indeed, disapproval of the Chancellor’s decision could be monitored.

Such transparency meant that decisions were more likely to be based on economic rather than political considerations.

Currently the minutes of the Monetary Policy Committee are published two weeks after the monthly meeting. The minutes include the MPC’s deliberations and the voting.

In addition, the Bank publishes its Inflation Report on a quarterly basis. The Inflation Report includes the MPC’s forecasts for inflation and GDP over the two-year horizon.

The Bank of England is able to conduct monetary policy via short-term interest rates through its role as banker to both the UK banking sector and the UK Government.

On a daily basis, funds flow between the private sector (companies and individuals), and the Government. These flows involve funds being transferred between the banks’ accounts at the Bank and the Government’s accounts.

Normally the flow of funds to the Government is greater than the other way around, leaving the banks, which need to maintain positive balances in their accounts at the Bank, short of the necessary funds.

The Bank of England meets these shortages by lending to the money market, doing so at the rate set by the Monetary Policy Committee (MPC).

A change in interest rates by the MPC quickly spreads to the other short-term sterling markets, through arbitrage.

Traditionally the Bank has relieved shortages through buying treasury bills and eligible local authority and bank bills.

Since early in 1997, however, the Bank has conducted its operations largely through the use of gilt repos.

The Bank invites institutions which are short of funds to sell assets such as gilt repos and eligible bills to the Bank, promising to buy them back in about two weeks time – repo is just short hand for sale and repurchase – or it might buy treasury bills and other eligible bills outright.

The repo rate, the rate set by the MPC, is reflected in the difference between the agreed sale and repurchase price in these transactions.

The Bank has also widened the range of institutions with which it conducts this daily round of business.

Traditionally, the counterparties were the discount houses but this has been extended to include those banks, building societies and securities firms which are able to satisfy a number of Bank of England requirements.

The yield curve depicts the term structure of interest rates - how rates vary as maturities move from short term (say one month money) through to long term (ten years or more).

The Bank of England Quarterly Bulletin (May 1999) notes that “a perfectly transparent, fully credible monetary policy will insulate the yield curve from jumps at the time of monetary policy changes.

Indeed, how stable the yield curve is, when monetary policy changes, provides one measure of the degree of transparency and credibility of a monetary regime.”

The article concludes that “evidence in the United Kingdom suggests that these yield curve shifts have been dampened considerably since the introduction of inflation targeting and the transparency reforms which have accompanied it.”

The market’s ability to read the Bank’s intentions has improved immeasurably. This ensures that there are few shocks which add sufficient ‘news’ to change the shape or slope of the yield curve significantly.

The UK in the 1970s and 1980s was characterised by high and variable inflation and an apparent inability on the part of the monetary authorities to bring it under control.

The UK’s inflation credibility was low and, in consequence, long-term interest rates had a built-in inflation premium. The UK yield curve was sharply upward sloping, making it expensive to borrow long term money.

The transfer of interest rate decision-making to an independent Bank of England, was seen as removing political bias in setting rates and built on the improved credibility which had been slowly building up in the first half of the decade.

Expectations quickly grew that the Bank would be successful in achieving the Government-set inflation target. As a result, longer-term rates fell sharply as market makers built in future inflation of 2.5% into their calculations.

The chart below (chart 4.1) shows the shape of the yield curves in May 1996, the year before the Bank of England took full responsibility for setting interest rates, in May 1997 when the Bank took control of policy and in May 2008. Over that period between 1997 and the first half of 2008, the shape changed markedly, becoming much flatter. Prior to the Bank being given responsibility, longer-term interest rates were well above short-term rates, reflecting uncertainty about future inflation.

That changed in the second half of 2008, however, when turbulence in the banking sector, including the collapse of several well known retail banks, lead to a lack of trust between financial institutions. As a result, the yield curve once again became sharply upward sloping but not, this time, because of worries about future inflation.

The upward shift in the second half of 2008 was simply because banks were unwilling to lend to each other. The problem arose because of worries about so-called toxic debt, a hang over from problems in the US housing market, and the whereabouts of that debt.

Individual banks simply were unable to gauge the financial health of the banks they would normally do business with.

One of the more important economic variables to be taken into account when forecasting the future path of interest rates is general economic activity as measured by Gross Domestic Product.

Over a comparatively long period of time the UK’s growth rate appears to have been relatively fixed. Though there is some debate over what that rate actually is, most economists would agree that it is presently between 2½% and 3% (see Estimating the trend rate of growth).

Should the economy grow faster than this rate for any length of time (assuming it has already reached the stage at which spare capacity has been used up) then the result will be increased inflation as demand exceeds the ability of the economy to supply that demand. So-called bottlenecks appear in the economy. Growth below trend for a period, on the other hand implies a build up of spare capacity - typically unemployment increases and plant and machinery becomes idle - and a reduction in the rate of inflation.

One of the tricks of the last decade, therefore, was to keep economic growth as close to its long-term trend rate as possible.

The above chart (see chart 4.2) shows that growth moved above trend in 1994, 1996, 1999, 2004 and 2006. The implication was that inflation two years later would also move above target.

In consequence interest rates were increased to slow the economy down to bring economic growth into line with its long run potential. Similarly when the growth rate falls below trend, monetary policy is loosened and interest rates reduced.

Policy works with a lag

These changes act with a considerable lag.

The Bank of England has estimated that its interest rate changes “have their fullest effect on output with a lag of around one year, and their fullest effect on inflation with a lag of around two years”

and that...

“temporarily raising rates relative to a base case by 1 percentage point for one year might be expected to lower output by something of the order of 0.2% to 0.35% after about a year, and to reduce inflation by around 0.2 percentage points to 0.4 percentage points a year or so after that, all relative to the base case.”

(See “The transmission mechanism of monetary policy” on the Bank of England’s website.)

Success in keeping inflation under control

In the period since its inception the MPC has largely succeeded in keeping the underlying rate of inflation within the two trigger points, whether under the old RPIX target or the newer CPI target.

In April 2007, however, for the first time, inflation moved above 3% and on 17 April the Governor wrote to the Chancellor “to explain why inflation had moved above target and what the Committee proposed to do in response.”

It has, however, also been occasionally criticised for undershooting the target for extended periods of time.

From April 1999 until the autumn of 2002, for instance, persistent undershooting led to some criticism that there was institutionalised bias towards low inflation which resulted from the Bank needing to establish its inflation control credentials.

The outcome of the new proactive policy, therefore, has been low and stable inflation and consistent and stable growth.

Although the cycle has not been eliminated, the troughs and peaks have been much shallower.

Moreover, because monetary policy action is taken early to moderate real activity, by its very nature it does not need to be as draconian as it would be if the response were delayed.

The economy in the 1990s and 2000s has been a world away from the high and variable rates of inflation which characterised the 1970s and 1980s and the high and variable interest rates which were needed to bring inflation back to an acceptable level.

The current policy will not, of course, eliminate cycles altogether nor does it mean that the economy will be able to avoid the effects of unexpected economic shocks such as the oil price hikes which occurred in the seventies and which returned in 2006 and 2008.

It should, however, ensure that harmful swings are dampened and provide an element of strength to the economy so that if and when external shocks do occur, the economy is well placed to minimise the impact.

The trend (or potential) rate of economic growth is defined as the rate at which the economy is able grow over a protracted period without increasing or decreasing inflationary pressures.

Economies can, for instance, grow faster than trend over short periods of time without causing inflation to rise but only if there is sufficient spare capacity.

Once that spare capacity is used up, attempts to grow faster than the “natural” rate will simply result in bottlenecks in the economy and a rise in inflation.

The natural limits to an economy’s ability to produce goods and services are: the number of hours that the work force puts into production and the amount of output that can be produced per hour.

The number of hours available depends on the size of the working age population (which in turn is dependent on the natural rate of growth of the population plus net immigration), the proportion of the working age population which is willing to work and the number of hours each worker wishes or is able to contribute.

HM Treasury’s economists have estimated (see: ‘Trend growth: new evidence and prospects’ December 2006 which can be found on the Treasury’s website) that the economy’s trend rate of growth is currently 2¾% and is likely to remain at that level over the next few years.

Breaking down this figure shows that:

• The growth in the number of people of working-age provides 0.6 percentage points
• The growth in the number of people within that age group willing to work adds another 0.2 percentage points
• The tendency for the average number of hours worked to fall over time is assumed to continue, reducing trend growth by 0.2 percentage points
• The increase in output per hour worked contributes 2.15 percentage points

The recent strong growth in the working-age population has been influenced to a great extent by inward migration which has boosted the supply of labour.

In May 2004, eight central and eastern European countries joined the European Union, and the UK government decided to allow the workers from these countries access to the UK labour market.

In addition, migration from New Commonwealth countries remained strong.

The Treasury estimates are for trend growth in non-oil gross value added rather than whole economy gross domestic product. Trend growth in the latter would be marginally slower.

Non-government estimates for whole economy GDP trend growth vary but are largely consistent with the Treasury’s estimates, ranging from 2.6% to 2.9%.

The UK government seeks to influence both productivity (output per hour) and employment (which determines the number of hours worked), the key factors in determining the trend rate and, therefore, the ability of a country to increase its economic wealth.

It can improve productivity via both macroeconomic and microeconomic policy.

The former entails providing economic stability, allowing companies and individuals to plan ahead more efficiently and, therefore, encouraging investment. For the latter, as the Treasury paper notes, this entails: improving competition; promoting enterprise; supporting science and innovation; raising skill levels; and encouraging investment.

The UK government has also sought to increase the employment rate – the proportion of the population willing to work through macroeconomic and microeconomic measures.

Economic stability since the early 1990s will have played its macroeconomic part.

Microeconomic policy has been concentrated on persuading people to move from welfare to work, so increasing the proportion of the working age population available to work.

These measures have been two-stranded with programmes like the New Deal making it easier for people to move into employment and measures such as the National Minimum Wage and Working Tax Credit designed to provide the financial inducement to do so.

Different central banks have different objectives

Although the Bank of England, the Federal Reserve Bank and the European Central Bank are all independent central banks, each responsible for its country’s (or, in the case of the ECB, countries’) monetary policy, there are significant differences between them.

The first major difference is in their objectives.

The Bank of England’s objectives

As noted above, the Bank of England operates with a clear inflation target (currently 2.0%) which is set by the UK government.

The target is symmetric in the sense that deviations either side of the target are seen as undesirable. By accepting that too low a level of inflation is unacceptable, the Bank’s target implicitly assumes that economic growth will not be allowed to fall too far below trend.

The European Central Bank’s objectives

Under the Maastricht Treaty, the European Central Bank is charged with deciding and implementing monetary policy for the EU, conducting operations in foreign exchange markets, looking after the official reserves of foreign exchange, and promoting the smooth working of payments systems.

It has no responsibility for the supervision of banks or the overall stability of the financial system. Although the ECB’s inflation objective of price stability is set by the Maastricht Treaty, the target is set by the ECB itself unlike in the UK where the Bank of England’s inflation target is set by the Government.

Critics of the ECB have pointed to the fact that the central bank sets its own inflation target and suggested that this reduces its accountability to the member governments.

Critics of the UK system, on the other hand, note that the fact that the UK Government sets the target means that the Bank of England is not totally independent of the Government.

The ECB’s one tailed target has also been the subject of criticism. Up until May 2003 this target was to maintain inflation below 2%, giving the impression that the Bank was indifferent between an inflation rate of 0% or 2%, and with the implication that this might introduce a downward bias to European growth.

In May 2003, however, in part recognition of this weakness, the Governing Council of the Bank announced that in future it would “aim to maintain inflation rates close to 2% over the medium term” underlining “the ECB’s commitment to provide a sufficient safety margin to guard against the risks of deflation.”

The change was also intended to tackle “the issue of the possible presence of a measurement bias in the HICP and the implications of inflation differentials within the euro area.” At the time eurozone inflation averaged 2.1% but spanned 1.0% (Germany) to 4.6% (Irish Republic).

The objectives of the Federal Reserve – the Central Bank of the USA

The Federal Reserve, in contrast, to both ECB and the Bank of England has a much wider remit. It does not concentrate solely on price stability but is also required by Congress to attend to growth and employment.

The Fed’s main instrument for conducting monetary policy is the ‘Fed Funds’ target rate. Changes to this rate, which is for loans of overnight money to US financial institutions, influence market interest rates in the same way as bank rate does in the United Kingdom.

The next major difference is the decision making.

Taking account of the evidence in making decisions

The Bank of England takes account of a wide range of economic variables when setting its interest rates to achieve its inflation target over a two-year horizon.

In effect, the Bank uses its forecast of inflation, based on those variables, as a quasi-intermediate target.

Both the Federal Reserve and the European Central Bank also look at a wide range of variables although, until the May 2003 changes noted above, the latter put much more emphasis on money supply growth, a legacy of the Bundesbank’s monetary policy on which the ECB is based.

From May 2003, however, the ECB announced that it would use “economic analysis to identify short to medium-term risks to price stability”, in other words, use forecasts of the main macroeconomic variables.

Monetary analysis would be used “to assess medium to long term trends in inflation in view of the close relationship between money and prices over extended horizons.”

A major criticism of the ECB since its inception at the beginning of 1999 has been its apparent lack of transparency.

The high degree of transparency of the Bank of England has already been noted above. The FOMC, too, is noted for its transparency.

Just as with the Bank of England, its minutes are published and similarly contain details of the voting. In addition, publications issued by the regional Federal Reserve Banks provide information on the Banks’ thinking and motives.

The ECB, on the other hand, does not produce minutes of its meeting although it has argued that the statement issued at its monthly press conferences is equivalent.

The structures of the decision making committees

The nine-strong Monetary Policy Committee includes the Governor of the Bank of England, two deputy governors and six others, two appointed by the Governor and four by the Chancellor.

The Federal Open Market Committee, the body charged with US monetary policy making comprises the seven members of the Board of Governors of the Federal Reserve System together with five Reserve Bank Presidents.

Of these five, the president of the Federal Reserve Bank of New York serves on a continuous basis while the other Reserve Bank Presidents take it in turns to serve one-year terms.

For the European Central Bank, the 19-strong Governing Council is the body which decides on monetary policy changes.

The Council consists of the President, the vice president and the other four members of the Executive Board, together with the Governors of the national central banks.

All the key decisions relating to monetary policy, including interest rates, are made by the Governing Council acting by simple majority voting.

Meeting schedules

The Governing Council of the ECB meets once every two weeks to consider whether any changes to policy need to be made.

The Monetary Policy Committee of the Bank of England meets once a month usually on the Wednesday afternoon and Thursday morning after the first Monday of the month.

Day one is taken up with a discussion of the current economic situation. Policy decisions are announced at noon on day two.

The Federal Open Market Committee, the body which conducts US monetary policy is charged with meeting at least four times a year.

In fact over the last two decades, there have been eight regularly scheduled meetings each year.

Currently meetings are held every six weeks, although should the need arise for prompt action, unscheduled meetings are arranged.

One reason which has been put forward for the much more frequent ECB meetings is that the Central Bank was new to the role of monetary policy and, therefore, needed to build up a degree of credibility.