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Innovation in UK Monetary Policy and its Lessons for Japan
- Conditions for the Introduction of Inflation Targeting -

April 19, 2007

Overview

The UK economy has been growing since 1992. Over the last decade in particular, the stability of the growth trend has been remarkable. This is partly due to the improvement in the UK's economic constitution, thanks to the introduction of free market principles, but another factor that cannot be overlooked is the Bank of England's (BOE) mobility in its operation of monetary policy. The UK is currently following a monetary policy of inflation targeting, and it is possible that this policy provided the opportunity for a long period of steady economic growth. The background reasons for the adoption of inflation targeting include a loss of faith in monetary policy due to a sterling crisis and the example of countries that had already introduced inflation targeting successfully.

The greatest problem in connection with the introduction of inflation targeting is the lack of a prescribed method by which to determine the "optimum target". For this reason, the BOE has been searching blindly for the "optimum target", making repeated systemic changes, including changes to the target. It has also operated a monetary policy in which the level of the policy interest rate in the short term has been linked to inflation expectations. This has allowed the BOE to take a forward-looking approach to policy operation, taking steps to stabilize the future trend of the economy and prices while exerting a degree of control over market expectations, without being excessively constrained by short-term price fluctuation. The BOE becoming independent from the Treasury in June 1997 helped significantly to increase the effectiveness of the Bank's inflation targeting policy. The BOE's Monetary Policy Committee (MPC) holds monthly meetings, at which the policy interest rate is decided by majority vote. The fact that there is a correlation between the policy interest bias of MPC members and prices is evidence that the operation of monetary policy by the MPC has been effective in controlling prices.

Most analysts agree that inflation targeting policy has been "successful" in the UK. One reason for its success is progress in converting the UK to a "service economy". Although goods prices must inevitably come under considerable overseas influence, the price of services strongly reflects domestic factors. For this reason, an inflation targeting policy, which would control the domestic anticipated inflation rate, would be highly effective in relation to the price of services. It would be fair to say that, because a policy of inflation targeting policy was pursued in parallel with the conversion of the UK to a "service economy", it has been still more effective in stabilizing prices.

As the stabilization of prices has become established, the BOE has been able to pursue its 2nd policy objective of monetary policy, namely, an approach to policy operation that takes account of the economy. One noteworthy aspect is an approach to policy operation with a focus on the price of housing. The sustained rise in housing prices that has ensued has made a significant contribution to the increase in the burden-bearing capacity of households. Consequently, consumer spending has continued to rise on the strength of increased household borrowing, the asset effect and cashing out. However, closer analysis of the present situation reveals that this monetary policy pursued in the UK, which has contributed to a long period of steady economic growth is beginning to reach the limits of its effectiveness. The growth of household debt that has accompanied the growth of consumer spending has caused household balance sheets to deteriorate and has reduced the control that monetary policy is able to exert over the economy. To restore the effectiveness of monetary policy household balance sheets will have to be improved. However, reducing household debt to a sustainable level within a short time frame would have a massive impact on consumer spending. Even if the debt is reduced over a longer time frame, the asset effect would no doubt be weaker than at present, and it is likely that the UK's consumer spending would weaken.

The example of the UK holds two implications for monetary policy in Japan, the future direction of which is in question. First, when introducing an inflation targeting policy, it is important to ensure still greater flexibility and transparency of policy operation. Second, it is important to adopt a monetary policy stance that is strongly geared to preventing the formation of a real estate bubble.

For further information on the content of this report, please contact: Takuya Nomura, Economics Department

Tel: 03-3288-4665
E-mail:nomura.takuya@jri.co.jp

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