Inflation Target of ECB and Bank Of England

Both have an inflation target as the primary objective.

The Bank of England have a target of inflation of CPI = 2% + / – 1

The ECB have an inflation target of below, but close to, 2%. Therefore, the ECB is less tolerant of inflation going above the inflation target. Evidence suggests the ECB is less willing to cut interest rates than say the Fed or MPC of Bank of England. Some have criticised the ECB of having an anti-inflationary bias at the expense of unemployment – this will be a challenge in current recession.

Other Objectives of ECB and Bank of England

The Bank of England have a target of low inflation, but, they are also asked to consider wider macro economic implications

Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy. Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can be damaging to the functioning of the economy. Low inflation can help to foster sustainable long-term economic growth.
From: Monetary Policy at Bank of England

Also, we have:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment.

Monetary policy framework

By Contrast the ECB targets just inflation

“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

From: ECB Monetary Policy

The ECB is of course responsible for 11 countries in the Eurozone, whearas the Bank of England is responsible for just the UK economy

• Should Low inflation be the primary objective of Monetary policy?
• UK Monetary Policy
• An evaluation of MPC in controlling inflation

Readers Question b) Why, with the aid of these policies, the government often fails to achieve its main objectives of a healthy economic growth, full employment, price stability and a surplus on the balance of payments?

Limitations of Monetary Policy in Controlling Inflation

Cost Push Factors

If there is an increase in cost push inflation. For example, if oil prices rose signficantly, it would become difficult to control inflation and keep growth high. If cost push inflation increases, Aggregate Supply shifts to the left causing inflation and lower growth. To reduce inflation the MPC could increase interest rates. This will reduce inflationary pressure but would further reduce Aggregate Demand and economic growth. Here there is a conflict between different objectives

Time Lags

If inflation increases the MPC can increase interest rates. However, there can be a time lag of upto 18 months before higher rates have the effect of reducing demand. Therefore, it might be too late.
Therefore, there is a difficult in predicting future inflation trends.

Other Factors Affecting AD.

Higher interest rates should reduce consumer spending. However, in practice it might not. There are several factors that determine consumer spending, apart from interest rates. For example, if consumer confidence is very high and house prices are rising. Increased interest rates may be insufficient in reducing consumer spending.

• Policies for dealing with economic shocks 

Readers Question: What do you understand by the terms ‘monetary policy’ and ‘fiscal policy’? Explain with reference to a country of your choice:-

a) How these policies have been used by the government to try to achieve its objectives

Monetary policy is the attempt to control macro economic variables in an economy (primarily inflation) through the use of interest rates. – Monetary Policy
Fiscal policy is the attempt to influence the level of economic activity through changing taxation and government spending – More on Fiscal Policy

The objectives of the government are:

1. low inflation CPI=2%
2. Strong economic growth, but, not inflationary growth. Increasing long run trend rate of growth
3. reduce unemployment
4. avoid large deficit on current account balance of payments

In the UK, Monetary policy has been given to the Bank of England. Therefore, the Bank of England has independence in setting interest rates. The government only set the inflation target of 2% inflation.

If the MPC predict inflation will rise above the inflation target then they will increase interest rates. Higher interest rates reduce demand and prevent the economy expanding too fast.

If economic growth is sluggish, then interest rates can be cut, lower interest rates boost economic growth and help to reduce inflation.

Fiscal policy is not used so much in modern economies, but, in theory can be used to prevent recessions or prevent inflation.

If inflation is a problem the government can increase tax rates and cut spending. These will reduce Aggregate demand, and therefore, reduce inflationary pressure.

In a recession, the government can increase AD, by increasing government spending and cutting taxes. Lower taxes increase disposable income. This helps increase economic growth and reduce unemployment.

• Evaluation of Monetary Policy in controlling inflation 

Readers Question: To what extent does the government influence the monetary policy commitee when they set the interest rate?

• In the UK, The Monetary Policy Committee has independence in setting interest rates.
• The government appoint members to the MPC. In theory they could appoint members who are more sympathetic to the ‘government’s point of view’. In practice they don’t. Nor do the government threaten to remove members for choosing a certain monetary policy.
• The government set the inflation target currently CPI = 2% +/- 1. In theory the government could change the inflation target or remit of the MPC. In practise they haven’t. However, if there was a serious economic shock. e.g. rising oil prices causing cost push inflation (stagflation – rising inflation and rising unemployment) some governments may be tempted to raise the inflation target from say 2% to 4%. In effect this is telling the MPC not to increase interest rates. In practise I think governments would have difficulty getting away with this. – Markets would soon lose confidence in monetary policy.

• The Government’s could threaten to change fiscal policy. For example, if the MPC keep interest rates higher than the government like. They could threaten to use expansionary fiscal policy. – Cut taxes and increase spending. In practise the government hasn’t done this.
• The Letter of Explanation. If inflation misses the governments target greater than 3% or less than 1% they have to write a letter of explanation to the chancellor. The MPC has always sought to avoid this. However, in theory the MPC could ignore the government’s inflation target and just write letters saying we are sorry inflation is too high. Although, I doubt the MPC would do that.
• Note since independence in 1997, economic conditions have been relatively benign. The government have been quite pleased with the economic situation. Therefore, they have felt little need to interfere with the operation of monetary policy. However, if we experienced real economic hardship, things may change.

See also:

• How the MPC set interest rates 
• MPC and the control of interest rates