Difficulties of Achieving Inflation Target

 

Q. TO What extent is Monetary policy in the UK able to keep inflation within the govt target of 2%?

Monetary policy in the UK involves the MPC of the Bank of England setting interest rates in order to control AD and therefore inflation.

Monetary policy is pre-emptive. This means that they forecast future inflation trends and if they believe inflation is likely to rise they will raise interest rates.

Higher interest rates will reduce AD (or limit the increase of AD). This is because higher interest rates increase the cost of borrowing reducing consumer spending and investment. Also, it makes saving more attractive therefore reducing consumer spending. Finall, higher interest rates increase the cost of mortgage interest payments. This is important within the UK because many households have a mortgage, therefore they have less disposable income to spend, reducing AD.

Fall in AD

The above diagram shows how higher interest rates reduce AD and therefore the Price Level keeping inflation low.

However there are several factors which may make monetary policy more difficult.

Firstly Monetary policy is not the only variable affecting AD and inflation. If consumer confidence was very high and wages were rising quickly, higher interest rates may not reduce AD and inflation could still occur.

Secondly, if there was an exogenous shock to the economy, it could be difficult to keep inflation within the target. E.g. if there was an oil price increase this would cause cost push inflation. To reduce inflation may require very high interest rates which would conflict with other objectives such as lower growth. The below diagram shows cost push inflation. To keep inflation low the MPC has to reduce AD a lot, this causes a big fall in Real GDP. The govt will dislike this and may prefer a higher inflation rate than a recession.

Cost Push Inflation

 costpush

A third difficulty with monetary policy is that it is difficult to accurately forecast future inflation trends. For example, if the MPC expect low growth, interest rates will remain low. However, if the economy expands quicker than they expect, inflation is likely to rise above its level. Also, there are time lags involved in increasing interest rates because it takes time for people to reduce their consumer spending and investment.

It is also possible that inflation could fall below the govt lower target of 1.5% if deflationary pressures set in, lower interest rates are often not sufficient to stimulate the economy( e.g. the experience of Japan in the 1990s ). This is due to a liquidity trap

However, since the B of E was made independent in 1997 inflation has remained close to the target -suggesting Monetary policy has been successful. However, the Bank has been helped by various factors which have kept inflation low. These include increased productivity, lower price of raw materials, a relatively strong £ and low inflation in the Euro zone.

However there is no guarantee that this will continue in the future

By on November 28th, 2012 in